Bracing times ahead?

IFR Russia and CIS Loans Roun
9 min read
Emerging Markets

Some had convinced themselves that the credit crunch, triggered by the sub-prime crisis in the US, would bypass Turkey. Alas, that has not proved to be the case and by the start of 2008 the pain had spread to its shores.

In fact, the economy was already showing signs of slowing at the end of 2006. But the illusion that emerging markets were decoupled and immune to the sub-prime flu held until credit taps dried up early this year. Turkey has now been badly affected, which – combined with the political pressures – explains the recent market selloff that has seen the local equity market among the worst performers of the year, while the lira has fared little better.

The lira is 20% down from its peak but it was arguably overvalued after a bull run of 12–18 months in 2006 and early 2007. Momentum was added to its downward correction amid fears about the credit problems, though Turkey has accumulated large reserves of dollars to hedge this problem.

“Given the higher-than-initially-anticipated real interest rates, further weakness in local currency and deterioration in consumer sentiment, we expect economic activities to ease in the remaining quarters of 2008,” said Seher Fazlioglu, economist at Global Menkul Degerler in Istanbul.

Inflation is a major policy challenge for Turkey. It had originally tied its currency to an FX basket before the 2001 banking crisis but has since moved to a floating currency to manage its inflation, but this has made the country uncompetitive. Although inflation now stands at 9% – with consensus it could be down to 8% by year-end – there is a danger it could be pushed higher, back into double digit territory, warned Fazil Zobu of Standard Unlu in Istanbul.

Yet the country also has a tradition of coping with crises. There have been many problems in Turkey over the past decade. What characterises this last political crisis in Turkey is how sanguine the markets have remained throughout.

Memories of 2001 loom large in Turkey’s financial psyche. The complete collapse of the banking sector was only averted by intervention from the IMF. “Crises make you stronger – eventually,” said Beat Siegenthaler, chief economic strategist at TD Securities. Banks are better capitalised now than they were before that crisis, which will help them this time round.

The fundamentals of Turkey are also quite strong. Its debt is sustainable and the currency is – at least normally – relatively stable. The black cloud is its enormous current account deficit, which stands at 6% of GDP.

The deficit was born of Turkey’s low savings rate and weak private pension system. High foreign borrowing gives it a currency mismatch problem that could get worse if the credit crunch deepens.

“Higher interest rates will attract some [currency inflow] but probably not enough to make a real difference,” said Fazlioglu.

Turkey is therefore arguably in a worse position than its EM peers but the situation is probably already as bad as it is likely to get, said Mehmet Mazi, head of HSBC’s emerging markets group for EMEA – though the market is proving more cautious this year and has a lower risk appetite.

Numerous commentators cite the current account deficit as Turkey’s biggest problem. The issue has always been there, but looks more intimidating now that the global economy has taken a turn for the worse. “It doesn’t look like it is going to shrink – so how is it going to be financed?” asked Mina Toksoz, head of country risk at Standard Bank in London. It is a question that echoes around the corridors of Istanbul’s banks and beyond.

The high foreign direct investment Turkey has hitherto enjoyed has been the perfect solution to Turkey’s funding problems as it does not add to the debt levels it has already accumulated. “Unfortunately it looks like FDI is going to slow down,” Toksoz said. In January and February 2008 FDI was around US$1.6bn, compared with US$7.4bn in the same period of 2007.

Otherwise, it will be possible for banks and corporates to continue to borrow from the international markets as they have done in the past, but that will cost more. The sharp decline in the value of the lira makes it easier to resolve the current account deficit, though on the flipside it is likely to deter foreign investors. It also makes life harder for those Turkish corporates not involved in exporting.

Crunch or no crunch?

It all adds up to a difficult year for Turkey. “If the credit crunch goes into 2009 then growth could slow down more sharply,” and could even lead to several quarters of stagnation, warned Toksoz. She puts growth at currently between 4.5% and 5%. It has already started slowing but this has not yet reduced the deficit.

But for Tolga Ediz, emerging market strategist at Lehman Brothers in London, the credit crunch has so far been a threat that has remained largely unfulfilled. "If the credit crunch gets worse then Turkey is going to suffer a lot," he said; but for now, although Turkey’s cost of funding has been increasing, it has not yet become a problem: balance of payments data and local investor feedback indicate Turkey still has no problem financing its debt in the international markets, he said.

Ediz predicted the country will end the year on around 3% growth, though if the credit crisis deepens the situation could be worse, with recession a real possibility. "We need pre-emptive interest rate hikes," said Ediz. "It would hurt bonds in the short term but they would recover."

The optimists can only fall back on Turkey’s experience in dealing with market shocks, especially of the interest rate and exchange rate variety, which stand it in good stead. Such shocks are more of a challenge than the secondary affects of the credit crunch, said Tolga Egemen, executive vice president of financial institutions and corporate banking at Garanti.

The slow pace of development with the current crisis coming out of the US and Europe means Turkish banks are prepared. “An interest rate shock is like an earthquake. This is more like a tsunami. The time to prepare is a big advantage, you can move to higher ground where you will be safe,” Egemen added.

Turkey in context

Emerging markets have been the darlings of many investment portfolios in recent years. They have in many instances proved themselves to have reached an impressive level of maturity and growing independence from the developed world, in particular the US. Their fortunes still depend to varying degrees on external factors but there has been a vital change in the relationship.

“In previous years this kind of a problem [the credit crunch] would have caused a crisis in Turkey,” said Andreas Schroeter, head of operations in Turkey for WestLB. “Now when Turks look outside and see problems it gives them confidence in themselves. Turkey is used to crises, so they can have confidence in themselves to handle this one.”

People like to compare Turkey and Russia, and Russia comes out on top at the moment, but this is due to its concentration of commodities, said Siegenthaler. Everything Turkey has achieved has come without that support. When the commodities cycle turns downwards, Turkey will be in an advantageous position of having little exposure in this area, and having a more diversified economy, he predicted.

“Turkey has had to work much harder [than other emerging markets] for the same level of development,” said Siegenthaler. “But it has a healthier structure and a broader base. It is an easy place to do business and it is not as bureaucratic as Russia. There are more viable businesses for banks to lend to and there is room for more growth.” While textiles and agriculture have seen weak growth recently, other sectors have picked up the slack, especially autos, with parts manufacturers supplying foreign producers. Over the medium and longer terms, he predicted, Turkey will prove better placed than commodity dependent economies such as Russia, Brazil or Indonesia.