Turkey 2006 - On the right track

IFR Corporate Hybrid Capital 2006
16 min read
Emerging Markets

Turkey is now in its fourth year of one-party, majority government and strong GDP growth. This is no accident. Almost all observers recognise the link between the AK Party's majority rule and the country's recovery from the crisis of 2001. During that time, the party – contrary to the initial fears of many – has maintained strong fiscal discipline, worked to bring down inflation, allowed the central bank to control rates, and encouraged strong GDP growth that has seen the size of the economy increase by an average annual 7% between 2000 and 2005. The question now is what happens next, both politically and economically, and what effect those developments will have on the capital markets.

The AK Party (AKP) is still dominant. In parliament, the party has a majority (363 out of 550 parliamentary seats), and the opposition remains fragmented, with only one other party represented in Parliament. There seems no doubt that if there were an election this summer, the AKP would win again. There is no need for parliamentary elections until November 2007 (elections are held every five years), although some analysts have raised the question of whether the government may opt for early elections to lock in another five years in power, taking it to 2011.

Another political kite being flown by some commentators is the question of whether Prime Minister Recip Tayyip Erdogan could choose to become the country's president when the present incumbent's term ends in April 2007. The president is appointed by parliament, and the AKP's current majority ensures that it can choose its own candidate. Given that the president serves for seven years, another such opportunity will not arise again until 2014, but the AKP would need to win two parliamentary elections (in 2007 and 2012) to be in a similar position to that it enjoys today.

The biggest development over the past year was the opening last October of negotiations towards eventual EU entry. This process is likely to take over 10 years, and there is considerable resistance in some EU countries towards the Turks' eventual membership. For a time it seemed that the Austrians would prevent negotiations even starting. However, the impact on sentiment towards Turkey has been profound (see articles in this report on ECM and DCM).

The government is also pushing for solutions to the issues of Northern Cyprus and the Kurdish regions within Turkey. Prime Minister Erdogan's references to the cultural rights of Kurds mark a notable change from the position historically maintained by governments of various hues in Ankara, for example. These issues will have to be resolved before Turkey can join the EU, and the government has won much praise for its pro-active stance, which marks a radical break from the positions maintained by successive previous governments on both the Cyprus and Kurdish issues.

Of course the sky is not cloudless. The AKP is under pressure from accusations about corruption and wealth acquisition by government members, and secular Turks – which include most senior bankers and the armed forces – continue to worry about the AKP's longer-term plans, particularly in the sphere of Islamic-inspired social reform. Some see the effective transfer of around one million jobs from central government to local government as a means of consolidating the AKP's power at the local level.

The prospect that the political stability of the last four years will continue is a very significant reason for confidence in the Turkish economy and financial markets. Cem Akyurek, chief economist at Global Securities, thinks that the big change compared with five years ago is that: "Turkey is now seen as a place where an investor can make a good return by buying and holding rather than trading in and out".

However, the economic situation is changing. "Turkey is at the very end of emerging from a period of crisis dynamics. Often such a situation is very favourable, with a reduction in inflation and strong growth. But this is coming to an end, and normal conditions are reasserting themselves," Akyurek said.

Inflation seems to be well under control. In 2005 the year-end figure was 7.5%, and for 2006 the government is targeting 5%. In fact, as Tolga Ediz, an analyst at Lehman Brothers notes, without the effect of high energy prices and increases in administrative prices (such as taxes on alcohol and tobacco) 2005 inflation was 6%. He adds that there are signs of a decline in service price inflation (restaurants, hotels), though the housing element remains high.

Other analysts agree that there is little evidence of inflationary pressures in the economy, but several see little scope for further declines in inflation and view the government's targets as optimistic.

Mina Toksoz, a country risk analyst at Standard Bank, said that it was hard to see inflation going below 5%, and Global Securities' Akyurek forecasts that inflation will end the year above 6%. Deutsche Bank analyst Tevfik Aksoy forecasts an inflation rate for end 2006 of 6.3%, compared to the consensus which he estimated to be around 5.7%. "To meet the government's 2007 target of 4% inflation, we would have to have slower growth, but with elections next year that is most unlikely," he added.

In fact, GDP growth looks set to continue strong. In 2005, construction and agriculture made big contributions, and for 2006 Aksoy forecasts 5.3% growth. On that sort of performance there is no need for the government to rush to the polls.

Like strong growth and falling inflation, declining interest rates have become a standard feature of the Turkish economic scene over the past four years. That looks set to continue, but analysts are divided over the speed and timing of that reduction. Lehman's Ediz expects the Central Bank to reduce rates gradually to avoid any monetary stimulus. "Interest rates remain high in real terms," he said. Ediz is forecasting a reduction of 225bp in the overnight central bank (CDR) rate by mid-2007 from the current 13.5%.

Standard Bank's Toksoz does not expect any cuts in interest rates in the first half of 2006, and thinks that they could even see an increase in the event of a reversal of portfolio flows. Global Securities' Akyurek agrees that a rate cut is unlikely in the first half, but thinks there might be scope for up to 75bp of cuts in the second half of the year. Deutsche's Aksoy forecasts a reduction of 100bp by the end of 2006.

The government's own finances are a prime beneficiary of the fall in interest rates, but that is only part of the story. The budget is in balance overall, with a primary budgetary surplus, thanks in part to ad hoc measures and increases in direct taxation. Revenues from income and corporate tax remain low, though the government is moving in the right direction on that score.

As well as the reduction in the cost of financing government debt, privatisation flows have played a role. As a result, Lehman's Ediz estimates that in 2006 government domestic debt issuance will be US$20bn lower than in 2005. The consolidated budget deficit for 2005 was about 2%, and the PSBR was lower, at around 1%. Deutsche's Aksoy thinks that in 2006 the PSBR could be even lower, perhaps zero or negative.

On the current account, there is still a large deficit funded mostly by portfolio flows. But there is little real concern about this situation. The trade deficit is around US$40bn, but that is no longer expanding so quickly. The biggest change in 2005 in this area was the huge increase in foreign direct investment. After years when FDI struggled to reach US$1bn a year, in 2005 it totalled US$8bn net and covered 35% of the current account deficit.

A large portion of that came from successful asset sales, both by the government and the SDIF, the body responsible for handling and disposing of failed banks' assets. For 2006, Deutsche Bank's Aksoy estimates that FDI will be over US$12bn. Some of that will be payments for assets sold in 2005, but there is real hope that the opening of negotiations with the EU has in turn opened a new phase in Turkish inward investment.

Medium term, analysts are hoping for FDI to be driven by a combination of M&A and greenfield investment. Standard Bank's Toksoz believes that the increase in FDI "should be enough to tide Turkey over until the debt/GDP ratio is lower."

Meanwhile, foreign investment in debt and equity remains the most important element in financing the current account. This has always been seen as dangerous given that such flows can be reversed, but Ediz points out that in Turkey's case, the volatility of those flows is very low.

"The important fact is that these flows are not short-term trading positions, but long-term investment. The lack of concern about the current account is reflected in the lack of TL volatility. Increasingly, the TL is immune to moves by the US Fed and news from other emerging markets as it comes more into the orbit of the EU," he said.

However, the potential for an outflow of portfolio investment is certainly there. Foreigners own about 70% of the free float of the Istanbul exchange, rising to over 80% of the top 25 stocks. The recent bull market has essentially been the result of foreigners buying from each other. Domestic retail investors remain on the sidelines, burned by past market downturns, while domestic institutions are more interested in the scope for yield pick-up from new corporate bond issuance. But if there is a market downturn and foreigners stop buying, the most likely result is a collapse in trading volumes rather than an outflow of portfolio investment.

The positive sentiment about the economy and the political scene is reflected in the strength of the currency. Lehman's Ediz forecasts a rate of TL1.37/US$ by the end of 2006, compared with a current level of US$/TL1.365. The Central Bank has made several large-scale interventions in the currency market in recent months. In the week of February 13 it bought US$5.5bn, but such moves are to build up foreign currency reserves rather than to manage the currency. With that last intervention, Turkey's FX reserves have increased to US$56.2bn.

There is general agreement that the TL is overvalued on a trade-weighted basis, which is affecting Turkish exports – Turkey exports mainly in euros. There was a recent example of the tensions resulting from the high exchange rate in the form of demands from the textile sector for assistance in the face of competition from Asian producers.

In the long run, Turkey is probably going to have to accept the loss or substantial downsizing of its textile sector in the same way as other developed economies – like the UK – did in the 1970s, when the beneficiary was Turkey. But it is hard to accommodate the additional social pressures that come from the recognition that the country is no longer a cheap manufacturing base.

Despite the years of strong growth, unemployment remains a problem. In part this is a function of the young profile of the population. A huge number of new workers come into the market every year; the economy created over one million new jobs in 2005.

In addition, Turkey has yet to complete the relocation of a substantial proportion of the workforce from agriculture to the industrial or services sector. Approximately 34% of the workforce is still employed on the land (2004 data), although the stubbornly high level of unemployment is also because industrial investment since 2001 has led to a huge boost to productivity.

It is evidence of the progress made in so many areas of the economy since the crisis at the beginning of the current decade that relations with the IMF are now very much in the background. There is no concern about Turkey's ability to its outstanding IMF loans, given the virtuous circle of government borrowing. And the government has showed a degree of fiscal discipline that must have impressed even the most optimistic IMF observer.

There are still elements of structural reform to complete, such as the new Social Security Law. Long delayed, there is some concern that if this does not appear before this summer, it may never happen and that its provisions – on the reform of the pension age, for example – may have been too diluted. However, this is a minor caveat on the eyes of most analysts.

Overall, attitudes towards the prospects of the Turkish economy remain positive. There is agreement that external factors are the main threats to the continuation of the recent positive trends, for example, a change in US interest rate policy, an escalation of regional tensions centred on Iraq or Iran, or a setback for the global hedge fund industry. The sense among economists is that the government is still on the right path, its actions over the past four years having repeatedly proved the doubters wrong.

"The track record of the Turkish government does not suggest that it will deviate from the goals that it has set," said Deutsche Bank's Aksoy. "But there are things, external in nature, that are completely out of their control, and it is those that could change the economic environment."

This comment is echoed by others.

"At some time the benign global conditions will change, at which point there will be a correction," said Global Securities' Akyurek. His recommendation to investors is to use any market strength in the first few months of 2006 to reduce their equity holdings, although on a longer-term view he sees further market upside.