Wednesday, September 22, 2010

Turkey - Breaking The Mold?

Turkey’s excellent second quarter GDP performance – second only to China in the G20 – has once more brought the country back into the focus of investor attention. Strong underlying fundamentals following major structural changes since the start of the century mean the economy is far more robust than it was. However, weaknesses remain, especially in the labour market and external trade balance, with the current account deficit continuing to be a cause for concern. Recent backtracking on the proposed fiscal rule legislation combined with loose monetary conditions raise issues about the willingness of the authorities to finally get the inflation driven external imbalances under control. Nonetheless Turkey remains the strongest economy in the CEE region, with low external indebtedness and substantial scope for above par catch-up growth.

  • Turkey’s economy surprised everyone on the upside in the second three months of 2010. The economy grew by a seasonally adjusted 3.7% over the first quarter, and by a China like 10.3% over the previous year. Turkey is one of the few countries in the CEE region to have strong independent domestic demand, making its economy relatively immune from short term movements in external demand.

  • While the general outlook is extremely positive for the Turkish economy, and rating upgrades can be expected, controlling the widening current account deficit will be the key to sustained success. In this context shelving of the fiscal rule legislation has sent out a strong negative signal to markets, not so much about current intentions as about the dangers of agenda slippage as we move further down the road. It is necessary to put this situation in some sort of perspective however, since government debt to GDP is still low, as is the level of household and external indebtedness. There are reasonable grounds, therefore, for optimism that once next years elections have passed, and with EU accession negotiations as an anchor, the overall policy mix can continue to evolve in a positive direction.

  • Turkey’s economy is now reaping the benefits of substantial structural changes on the macro front, aided by very strong underlying demographics. Turkey’s working age population is set to rise significantly in the years to come, posing a challenge for job creation, but offering the country the prospect of ever lower dependency ratios and strong internal demand momentum. In contrast to many of its regional neighbours the country has taken the opportunity offered by the strong underlying global environment of the early years of the century to set some of its ongoing macro problems straight, and in particular to put its national balance sheet in order. Thus it has avoided the accumulation of excessive debt, whether public or private, internal or external. Handled responsibly the country now faces the prospect of rapid convergence towards developed economy levels of activity and living standards between now and the early 2020s.


It is not hard to see why many investors consider Turkey to be a compelling destination for their investments at the present time. With a growth rate which equalled that of China in the second quarter driven by a strong expansion in consumer demand - car, home and consumer durable laons have now risen every week since January - the logic behind a bullish stance towards the country is all too clear. And there is no real mystery about the country’s recent success, since following a series of substantial structural reforms introduced in the wake of the 2000/2001 crisis Turkey’s macro fundamentals are now strong, making the country stand out clearly from the majority of its Eastern European Emerging Market peers due to vibrant internal demand and the comparative absence of banking sector issues. In addition, despite some recent concern over the medium term position the country still has a relatively sound fiscal outlook (together with comparatively low levels of both government and private debt), a secular disinflation trend and very favourable demographics which see the country’s population set to grow by over 1.5 percent per annum over the next 25 years.

On the other hand, not everything is going to be simply plain sailing in Turkey. The trade and current account deficits are swelling at a worrying rate as imports recover from last year’s slump. The foreign trade deficit jumped from $5.6 billion in June to $6.4 billion in July, the highest level since August 2008. In fact contrary to the CEE trend, auto sector exports actually fell in July, with overall export growth slowing to 6 per cent year on year, while imports of motor vehicles surged, producing a 24.6 per cent surge in overall imports.

The latest data suggests the current account deficit could be well over $38 this year, double last year’s level, and if current trends continue it could be up in the region of $50 billion, or around 7 per cent of GDP, in 2011.

Also of concern is the inflation rate, which rebounded again in August after falling for several months. This ongoing inflation differential with its trading peers is putting pressure on the real exchange rate, and on the competitiveness of the manufacturing sector. In addition, the quality of the financing which Turkey is receiving could become a cause for concern, since the share of FDI has fallen, while the increasing dependence on short term sources of funding like loans and equities if not corrected raises the risk of an unorderly correction at some point in the future.

Vastly Improved Fundamentals

Before the turn of the century crisis, Turkey’s economy was effectively characterised by an ongoing series of booms and busts, as consumption booms generated by unrealistic wage increases lead to competitiveness losses, over-indebtedness and an inevitable erosion in investor confidence which caused the whole thing to unwind. The IMF supervised strengthening of the country’s macroeconomic policy framework in the early 2000s decisively broke this pattern leading to a considerable decline in country risk premia.

The post 2001 reforms vastly improved economic resiliency, productiveness and efficiency. The implementation of an IMF inspired programme of strict fiscal discipline meant the budget deficit fell sharply from 12.9 percent of GDP in 2002 to a low of 0.3% in 2005. While the level of deficit rose again during the crisis (hitting 5.9% in 2009) this uptick is not exceptional when seen in a wider context, and the fiscal position is now expected to improve rapidly as the economy expands. The government’s debt to GDP ratio also fell substantially, from 93 percent in 2002 to the current level of just under 45 percent. At the same time the Lira has become a much more stable currency and interest rate levels have fallen substantially.

Very Strong Second Quarter

After turning in an 11.7 percent annual growth rate in the first three months of the year, the economy continued to recover strongly in Q2, turning in an impressive 10.3 percent growth rate, which was only equalled by China among the major economies, while only Singapore and Taiwan turning in better performances globally. Quarter on quarter the economy grew by 3.7 percent, or at an annualised rate of 14.5 percent.

The growth leaders in Q2 were construction, fisheries and manufacturing industries, which posted growth rates of 21.9 percent, 15.7 percent, and 15.4 percent, respectively. Industry and Trade Following the announcement of the figures Minister Nihat Ergün suggested Turkey could well grow by an annual 7 percent this year (up from a previous 6 percent forecast) and we do not find this suggestion at all unreasonable.

Unlike many of the over indebted economies which are to be found in the region (where growth is totally export dependent) the main engine of growth in the Turkish case is domestic demand, and in particular household consumption and investment. The construction and manufacturing industries grew by 21.9 percent and 15.4 percent growth, respectively, and both of these have high potential “multiplier effects” which means that they can reinforce growth in other sectors like retail sales and services in the second half of the year.

In fact Q2 GDP growth was significantly stronger than we expected, and well above the 8.5%Y consensus estimate, suggesting that the recently revised IMF forecast of 6.1 percent growth for the whole year may well need to be further adjusted upwards. Certainly the governments expectation of around 7% is far from being unrealistic. Export growth, which was up 12.1 percent on the year, was one upside surprise as was the rise in private consumption (up an annual 6.2 percent), although the latter was reflected in a surge in imports (up 17.8 percent) which meant the net trade contribution was negative (by 2 percentage points). Investment was up an impressive 28.7 percent, but this is not quite as impressive as it seems, due to the low base effect of the 2009 performance.

Public spending also accelerated, growing by 3.6 percent, although since revenue was also up the deficit actually fell over the period. Inventory growth, which contributed strongly (8.3pps) to headline growth in the first quarter, was modest (only 0.6pps) in the second one, suggesting we may see a gradual slowdown in manufacturing growth in the coming quarters. Indeed recent PMI readings have already begun to confirm this impression.

However, given that the Turkish economy actually plunged by "only" 11.0% year on year in the first half of 2009, GDP in real terms in the first half of 2010 was actually marginally up relative to its level before the onset of the global crisis, implying some real economic gains were made in the first half of the year, and that we are now truly talking of “recovery” in the Turkish context. The annual growth rates will evidently slow in the second half of the year, since Turkish economic conditions began to improve in the second half of 2009, with GDP falling only 2.7 percent year on year in the third quarter and the economy actually growing a seasonally adjusted 2.3 percent in the fourth quarter as compared to the third. Because the recovery had begun in the second half of last year, the base effects will affect results in the second half of this year, bringing annual GDP growth rates downward relatively sharply.

As stated aboveTurkey stands out from many regional peers as not being export-dependent and has a dynamic domestic economy to complement the export sector, which means the impetus behind overall GDP gains is much more broadly based. The strength of domestic demand also gives the Turkish government a far larger and growing potential tax base.

Unemployment rate continues to edge downwards

One of the reasons that domestic consumption is doing so well is the continuing fall in the unemployment rate, which stood at 10.5 percent in June, down from 11 percent in May, and 13 percent a year ago. The drop is evidently leading housholds to have an increased sense of job security and purchasing capacity.

Just as importantly the country is creating jobs. When compared with June 2009 the number of those employed rose by more than 1.5 million (to around 23.5 million), with the share of those occupied in the industrial sector (19.7 percent) rising significantly. Compared with a year earlier employment in agriculture was up 0.2 percentage points, while in industry it rose by1.2 pps, and in in services the share was actually down by 1.6 pps.

Under the impact of the global financial crisis, Turkey’s unemployment hit a record high of 16.1 percent in February 2008. Two years later, and in sharp contrast with most of its regional peers, the country has achieved an impressive drop in the jobless rate, and government forecasts that the rate may well fall to the single-digit level in the coming months do not seem unrealistic. Even more significantly, Turkey has achieved this improvement even as the labour force has risen sharply, from 51.6 million to 52.5 million. This feature again puts Turkey in a very different position to its regional peers, most of whom have either stagnant or falling labour forces due to their negative demographic trends. Turkey is evidently benifiting from phenomenon known as the “demographic dividend”, whereby as fertility falls ever higher proportions of the population are to be found in the working age category, initially boosting employment and output, and then, in a second wave, fuelling credit and consumption growth. Turkey is thus rapidly approaching the demographic “sweet spot” where sustainable rapid catch up growth is totally realistic and achieveable.

However, this process is far from automatic, and depends for its effectiveness on continuing and deep structural reforms. As the OECD are quick to point out, the Turkish economy makes far from satisfactory use of its existing labour resources. There is constant pressure on the industrial and service sectors to create the jobs to absorb the rapidly growing working-age population and enable the authorities to cope with the high rate of migration from rural areas. Turkey’s employment rate, at just above 40 percent, remains the lowest in the OECD area. Deep rooted socio-cultural factors, combined with the steady drift from rural to urban areas, mean that many Turksih women continue to withdraw from the labour force on marriage, which means the employment rate for women remains stuck around the 20 percent level, 40 percentage points lower than the equivalent rate for men.

Three Challenges – Inflation, The Current Account Deficit And Fiscal Control

Despite the fact Turkey is experiencing a secular disinflationary tend, the inflation rate rose in August, to 8.3 percent from 7.6 percent in July, reversing what had previously been a three-month run of declines. The main culprit, as is often the case in Turkey, was an increase in unprocessed food prices, reinforced by seasonal factors such as the arrival of Ramadan. In fact the surge was not unexpected, since Turkey’s central bank had previously forecast just such a “noticeable increase” produced by the seasonal jump in the price of fruit and other foods. The Bank has now kept its benchmark interest rate unchanged at 7 percent since November 2009, even as the economy returned to growth, basing their argument on the fact that the core inflation rate is falling toward the year-end target of 6.5 percent. Given that one of the key objectives of the central bank has to be reducing the level of interest rates they are unlikely to move rapidly towards monetary tightening and could resort to other tools to keep inflation in check, such as increasing reserve requirements to control credit growth. They are also likely to be reluctant to do anything on the interest rate front which could lead to an increase in short term capital flows, focusing their attention rather on bringing long term rates down to encourage FDI inflows.

The bank’s preferred measure of underlying inflation, ie excluding energy and food prices, fell to 4.2 percent in August from 4.5 percent a month earlier. On the other hand, they will also have noted that producer prices rose 1.15 percent during August (or 9 per cent over August 2009), a much faster pace than consensus expectations, a detail which may not alarm them but will certainly give them food for though. At the end of the day we doubt any of this will have much impact on the Bank’s policy stance, since they will surely stress that of the 9 core measures of inflation they track, six still posted annual declines in August. Indeed Central Bank Governor Durmus Yilmaz indicated at the start of September that in his opinion interest rates should stay on hold for the rest of this year, with only limited rises to be antipated in 2011. At the same time he has stressed that his ability to deliver on this front is conditional on fiscal decisions keeping to anticipated targets.

Current Account Deficit Worries

Turkey’s current account deficit increased sharply in July, and came in well above consensus expectations (US$3.0 billion). This means the current account deficit for the first seven months of the year totalled US$ 24.2 billion, up from US$ 7.9 billion registered in the same period of 2009. Even the non-energy current account deficit was up significantly, hitting US$6.5 billion in the first seven months compared with a surplus of US$6.5 billion in the same period of 2009. The underlying deterioration reflects the strength of the domestic consumer rebound and the impact of the inflation-driven real exchange rate appreciation.

Turkey has a long history of persistent current account deficits, and following an easing of the problem during the recession, with the recovery the old problem has simply re-emerged. During last year’s sharp contraction, Turkey’s current account deficit fell back to 2.3% of GDP, and the issue subsided as a problem. But last year's narrowing was due to very exceptional circumstances (the sharp contraction in domestic demand during the global financial crisis), so the anticipated widening of the deficit to a possible 7% of GDP in 2011 is essentially a reversion back to the norm. Which does not make it any the less problematic.

In addition to the rapid deterioration in the deficit, a further concern is raised by the quality of the financing which is supporting it. Capital inflows are increasingly short term and debt-based, while FDI (which is one the most stable and desireable ways to finance) remains below 2009 levels. At US$ 3.3 billion, FDI inflows over the first seven months fell short of the US$ 4.1 billion which entered the country during the same period of 2009. During the first six months of the year FDI coverage of the current account deficit came in at just over 10%, compared with 46% coverage over the same period in 2009.

As a result Turkey is becoming dependent on capital inflows which are increasingly short term and debt-based, making the country vulnerable to any renewed bout of risk aversion, which could see a rapid reversal in flows, triggering an abrupt adjustment in the real economy. There is one saving grace though, and that is to be found in the Net Errors and Omissions (NEO) category. This captures capital flows which remain essentially unidentified, and these dramatically improved during 2009, accounting for roughly US$5 billion in inflows. Although the dynamic behind such flows is unclear, movements are widely believed to reflect funds held abroad by companies and individuals which are repatriated during times of financial stress. These flows could be considered as a kind of automatic financial stabiliser (or cushion) for the Turkish economy, and it is not surprising to find that as conditions have improved so last year’s massive NEO inflow has steadily subsided, falling back to 0.5 billion $US in the first seven months of the year, from the 6.3 billion $US level seen during the same period last year.

With Turkey’s 2010 growth set to be much stronger than expected, the rapid widening of the current account has once more emerged as a key policy issue. A recent comprehensive analysis by the IMF argues that the root of the problem is Turkey’s considerable competitiveness gap. The IMF draw attention to the following evidence for the existence of the problem: (i) an above-normal current account gap - the IMF consider something like 2.5% of GDP to be normal in the case of an emerging economy like Turkey; (ii) real effective exchange rate appreciation driven by inflation differential between Turkey and its trading partners; and (iii) stagnation in the market share of Turkey’s exports.

The IMF analysis has implications for the secular outlook for the lira, since given that Turkey has a floating exchange rate regime, since if the loss of competitiveness reaches unbearable proportions the lira inevitably adjust downwards, an outcome which would not be unduly disruptive given that the country's external debt ratios are still modest, and that Turkey certainly does not have the same sort of problems many other emerging economies in the region have in terms of forex loan exposure.

Fiscal Policy Connundrum

Despite increasing during the crisis, Turkey’s fiscal deficit has been low in recent years, and debt to GDP has fallen steadily. The deficit hit 5.6% of GDP in 2009, and the IMF project it will fall to 3.4% by 2011. Gross debt peaked at 45.5% of GDP in 2009, and is now set to fall back steadily.

government to shelve the proposed Fiscal Rule legislation which would have committed the government to target a 1% fiscal deficit has come in for a lot of criticism, most notably from the IMF in their latest Article IV country report. The decision seems to reflect government concerns not to prematurely tie its hands in the face of what might be a quite closely contested election in 2011. Turkey, in the words of Fitch country analyst Edward Parker “somewhat tarnishes its fiscal credibility” by delaying the decision to place limits on budget spending, especially as the move suggests it may run a larger budget deficit next year than planned. At the same time Fitch stressed that it does not make any direct linkage between legislating the rule and future ratings decisions - “Fiscal outcomes are more important than fiscal rules. The path of the budget deficit and goverment debt-to- GDP ratio are likely to be important drivers of future rating actions. The passing or non-passing of rules alone will not be”. Which is indeed fortunate for Turkey, since the latest data showed that the country posted a budget surplus of TRY3.1 billion in August compared with a TRY1.5 billion deficit in the same period last year. So despite credibility slippage, in the short term the strong economic expansion may well assuage concerns about longer term sustainability.

But looking further into the future, as the International Monetary Fund warns: “Failure to pass the rule quickly may forfeit the window of opportunity that could close ahead of the approaching election cycle, and risk weakening the credibility of the authorities’ commitment to fiscal discipline.” Thus by taking what seems to be the easier path now the government may be storing up trouble for the future. Spending the lions share of this year’s excess tax revenues is only stimulating an economy which is not in need of stimulation, whereas saving them would not only be building a cushion for the future, it would also help reduce pressure on the current account deficit by draining some demand from the economy. As Turkish Central Bank Governor Durmus Yilmaz emphasised recently, fiscal and monetary policy simply form different pillars in one common strategy, and the central bank’s ability to keep interest rates low enough to keep make investment sufficiently attractive depends in part on government determination to keep to a medium term plan which limits the deficit. In order to preserve and reinforce domestic and international confidence in the sustainability of public finances, the Turkish government would be well advised to establish a clear and transparent framework for the future development of the deficit. As has unfortunately become only too clear in the case of the current Eurozone crisis, good times don’t last forever, and weakening vigilance when the pressure to take decisions is low often simply stores up even bigger problems for the future. It is far easier to take hard economic decisions when the winds are favourable, than it is when you face a tempest head-on.

Outlook Stable - Gradual Monetary Tightening, Ratings Agency Upgrades and Growing Political Consensus

While Turkey's central bank left its policy rate of choice, the one-week repo rate, unchanged at this months meeting, this decision responds to a number of policy objectives and there is little room for complacency on either the monetary or the fiscal front at this point if undesireable distortions are not to be produced in the real economy.

During the course of the crisis the central bank lowered rates 13 times from their October 2008 high of 16.75 percent, bringing the one-week repo rate to its current level of 7 percent. Evidently the Bank’s objective is to bring the level of interest rates permanently down to well below their historic levels, but their ability to do this is conditional on their success in reducing the endemically high levels of inflation which plague the economy. And as if to offer us a timely reminder that the problem remains with us, as we have noted inflation ticked up again in August to 8.3 percent.

Thus, as the IMF argue, bringing forward a moderate tightening in the monetary environment now could obviate the need for a sharper and larger tightening later on. A delayed tightening could be counterproductive since it might well attract further sizable capital inflows and be detrimental to banks because of their maturity mismatch. Tightening should be broad based with the aim of raising real borrowing costs and moderating inflation expectations. And as Governor Yilamz is arguing even greater recourse to contractionary monetary policy - with all the attendant risks - will be needed if the appropriate fiscal adjustment is not forthcoming.

Monetary tightening does not necessarily mean ongoing hikes in interest rates, removing the vestiges of the credit easing measures introduced during the crisis would also help, for example by tightening loan classification rules and increasing provisioning requirements. Naturally these measures are just as unlikely to prove popular with banks (and the builders and developers they lend to) as are fiscal tightening measures likely to win votes with electors, but in both cases the moves are necessary to provide for the long term health and stability of the economy.

A further measure which could prove useful would be increasing the volume of FX purchases by the central bank, this would serve the dual purpose of reducing liquidity and aiding competitiveness by reducing the impact any upward drift in the Lira produced by increases in the policy rate.

Rating Upgrades In View?

All the above is doubly to the point given that in the wake of the considerable strengthening of its macroeconomic policy framework and financial sector supervision, Turkey has significantly improved its terms of access to international capital markets. As a result, both during the crisis and in the current recovery period, Turkey’s risk premia has evolved very favourably, significantly reducing borrowing costs for government, banks and non-financial corporations. The country’s sovereign credit rating has been upgraded in recent months, although it has not yet reached “investment grade”. Further improvements in Turkey’s international capital market standing are to be anticipated, but in this context it is important that the subsequent lowering in long-term capital costs serves to stimulate long-term sustainable growth, and not get diverted into an unsustainable construction and consumer credit boom of the kind which we have just seen in some CEE peer countries.

Moody's Investors Service recently upgraded Turkey's government bond rating to Ba2 from Ba3, and the outlook was changed to stable from positive. An further upgrade from S&P’s, who raised Turkey's long-term foreign currency and local currency sovereign credit ratings to BB and BB+ in February, would not be a surprise. ." Among other comments of interest they said at the time they believed Turkey's banking system to be one of the strongest and least-leveraged in Eastern Europe and noted that local capital markets are continuing to develop, enabling the government to begin to place local currency debt at maturities as high as 10 years. Their decision to maintain a positive outlook on the rating is a reflection of the possibility of further upgrade over the next 12-24 months. Fitch’s last move was in 2009, when they rated Turkey BB+.

Moody's decision to only move Turkey up one notch was rather conservative, since for reasons best known to themselves the agency still rates Turkey one notch behind Egpyt, but it does reflect the way the agencies are, at least in Turkey’s case, rather behind the curve in comparison with the markets. Turkey CDS (in the 160 to 165 bp range) now consistently trade below higher rated counterparts such as Romania (BB+) and Hungary (BBB-, investment grade).

Turkey’s external debt ratios are still low (gross debt 43.4% of GDP, net debt 26.7%) and the country certainly does not have anything like the problems other emerging European countries have in terms of of the external liabilities of households and corporates. Thus they could live with a weaker currency and they have proven willingness to pay since they did so in 2000/01 when the temptation to restructure must have been very strong.

The principal obstacle to upgrades at the present time seems to be the shelving of the fiscal rule legislation, but matters may well change on this front after next years election.

Essentially, despite the fact that growth will slow somewhat in the second half of the year we still expect Turkey to be the fastest-growing economy in the region, with risks mostly centred on the external environment (growth in the EU, and global risk appetite) although evidently continuing domestic political stability such that consumer confidence is maintained is also critical, and it should be noted that confidence has slipped back in recent months. In this context the result of the recent referendum vote – which was solidly in favour of the government proposed reforms – augurs well for the future.

The outlook is then for growth in the 6 to 7 percent range in 2010, followed by a further 5 percent in 2011, especially with the likelihood of additional pre-election spending on the part of the government. Fixed capital investment should continue increase at a brisk pace in the second half of the year, buoyed in part by faster privatisation - Turkey’s state asset sales agency recently recieved 12 bids for a 36-year license to operate the Iskenderun port in southern Turkey. The port, one of the largest in Turkey, serves south and southeastern Turkey as well as Middle Eastern countries.

At the same time given the robust expansion in domestic consumption – bank credit to households is rising at a 40 percent annual rate – any slowing of demand for Turkish exports from Western Europe as fiscal tightening sets in will not have as much of a dampening effect on GDP gains as it will elsewhere in the region, although there will evidently be some impact. Despite pre-election spending we anticipate a somewhat lower growth rate due to base effects, tightening liquidity and an expectation that export conditions may well remain depressed.

Finally it should be stressed that the country needs to address the two major structural weaknesses which hinder growth. In the first place it needs to stem the loss of international price competitiveness which tends to occur during cyclical upswings, worsening the current account deficit. As growth strengthens, capital inflows gather pace, the exchange rate appreciates, and increases in minimum and average wages accelerate, leading the internal and external imbalances of the economy widen. To make lasting progress in breaking out of this cycle the inflation problem needs to be brought definitively under control via the utilisation of adequate and appropriate monetary and fiscal tools and the implementation of systematic labour market reforms. At the same time, the structurally low employment ratio needs to be corrected, in particular by ensuring improved labour market access for the country’s female population. Only in this way can the excessive dependency ratios be reduced, and the country’s saving ratio increased in a way which reduces dependence on external sources of funding.

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