What next for Turkey?

What next for Turkey?

Originally published in the September 2007 issue

Investors have had a good run since the dark days of the 2001 currency crisis and this July’s election produced no nasty surprises. So is it more of the same to follow or are Turkey’s risk factors a step too far? Averaging over 7% real GDP growth for the last five years, the country is proving itself to be a booming emerging market. Moody’s describe its outlook for government’s local and foreign currency debt rating of Ba3 as “stable”. The OECD’s October 2006 Economic Survey praised the Central Bank’s economic management: “The Turkish central bank has gained much credibility and achieved an impressive record in lowering inflation since being made independent in 2001 and charged with the task of disinflation. Tight fiscal policies, structural reforms and high productivity growth also contributed to the disinflation process…”

From many angles the Turkish story has been a positive one. The factors that have excited investors’ interest have been the country’s pivotal geopolitical position, its growing economic and political closeness to Europe and general economic and political stability. The re-election of the Justice and Development Party (AKP) with a strong mandate in the 22nd July election, further endorsed the good news. It might have gone horribly wrong, but it didn’t. Against this background a number of Turkey specific funds recorded double digit returns, especially in financial services and oil-related stocks. The Turkish Lira appreciated significantly rewarding those who chose a currency play.

Risk factors

For every strength and potential upside that Turkey offers, there is corresponding weakness and possible downside risk. Whilst the outcome of parliamentary election was a relief, political attention has now turned to the crucial presidential one.

Post general election analysis by Capital Economics’ Neil Shearing describes the current uncertainty, “…While it is right to interpret the election result as positive for the economy, it is also important to recognise that risks to political stability have not disappeared altogether. Parliament still needs to elect a President and the AKP will need to compromise if it is to get its candidate accepted by parliament and avoid irking Turkey’s secular elite…” As this is written, the ruling party appears in a mood to select a more secular candidate.

Similar and much greater long-term uncertainty shrouds the much-mooted EU membership question. Moody’s May 2007 Credit Opinion commented, “…The military inserted itself into the presidential election process, warning the government that it would not hesitate to defend the country’s secular character. This is likely to complicate the EU membership drive further.

“Already last December, the European Commission suspended negotiations with Turkey on 8 chapters of the ‘acquis communautaire’, and it will not close any other chapters until Turkey agrees to open its borders to Greek Cypriot trade. The impasse arrived barely more than a year after the formal start of membership talks and less than two months after Turkey completed the screening process… A compromise that would unblock the negotiations is unlikely to materialise in the short term…”

The Kurdish issue, risk of terrorist action by Islamic extremist groups and reported local support for military incursions into Iraq pose further political questions on which investors will have to make their own judgments. Many however will focus upon economic risk factors because hard data is available and it seems to speak for itself.

Economic outlook

Capital Economics and Moody’s have both suggested that GDP growth this year and next may slow to 5.5%. Inflation may also fall back a little but may still be as high as 7%. This is a remarkably low level as compared to almost 30% reached in 2002 following the crisis, and may lead to a cut in interest rates. However, much analyst concern has focused on the current account deficit, a major component of which has been the very high cost of imported energy. Recently The Economist noted, “…Its current-account deficit has not hit the Icelandic extreme but, at around 7.5% of GDP, it is still a gaping hole…”

Not everyone is so concerned about this. Morgan Stanley’s Serhan Cevik emphasises the positives, seeing the deficit as the flip-side of economic growth, “I never care much about the current account deficit in Turkey,” he says, “simply because the composition of the current account deficit is far more important than the one number that [commentators] keep scrutinising… 60% of the widening in the deficit is because of high energy prices and this is not consumer driven. The second factor is strong growth, which has led to increased investment and increased import of capital equipment…”

He points out that Turkey has, in general, moved away from labour intensive industries and into capital intensive ones, such as, for example, assembly plants for cars for export to the European market. This tends to up the short-term import bill. In the meantime there is plenty of evidence to suggest that foreign investors have voted with their cash as to their view of Turkey’s investment potential.

Mr. Cevik points out that many anticipated the outcome of the July general election and there was a significant inflow of investment funds beforehand. He says that once the result was known there was “a certain amount of profit taking combined with turmoil in global markets” which “limited the post-election upside.”

This however needs to be viewed against the backdrop of burgeoning global liquidity of which Turkey has been a significant beneficiary. ” After a brief period of adjustment, higher interest rates, coupled with strong economic fundamentals, have attracted even more foreign capital into Turkish markets [than in the period 2002 to April 2006],” writes Cevik. “Although the Lira’s sudden depreciation last year altered the behavior of residents (who then accumulated $30 billion in foreign currency-denominated instruments), foreign investors have become even more enthusiastic.According to the latest data, foreign holdings of equity and domestic debt increased to $81.5 billion, especially as non-residents accumulated 21 billion Lira in domestic debt since last summer. As a result, non-residents own more than 70% of free float in the equity market and 37% of non-bank holdings of domestic government debt.”

Gaining exposure

The extent to which hedge funds are holders of Turkish equities, debt and derivative instruments is unclear. There are no available statistics but many funds are of the opinion that hedge fund activity is widespread among these asset classes and they are likely to be significant players in the derivatives market, especially in Lira/US$ and Lira/€ instruments. Moreover these funds are overwhelmingly foreign in their origin as the development of local hedge funds is at an early stage. A consultation on proposed amendments to “Free Investment Funds” (FIF) Regulation, which does not permit the launch of such funds in Turkey, was only called for in September last year.

Gaining exposure to the Turkish market is still restricted, especially as many prime brokers see insufficient activity to justify providing funds with access to the relatively small Turkish market. In contrast, boutique houses, such as Global Trader, require much smaller volumes to justify covering a market. As a result, while an increasing number of funds execute all their CFDs transactions with Global Trader, others are using it specifically to access Turkey and other similarly dynamic markets. This enables a fund manager to extend his or her instrument universe free from such selection constraints.

In the final analysis, as an emerging market play Turkey offers some genuine attractions. Its risks, opportunities and volatilities have yielded good returns in recent times with continuing economic growth fuelling prospective returns. Certainly there are medium-to-longer term uncertainties and it is these that condition the scale of available upside – caveat emptor – as ever.