Turkish delight comes with health warnings

By bne IntelliNews December 2, 2010

Justin Vela in Istanbul -

Turkey's markets received well-earned attention in 2010. However, the country will carry a series of risks into 2011 that is making some investors wary.

"The chances are that, tactically, all Turkish assets might continue to appreciate. Our point is that the risk-reward on a relative basis looks better in other parts of emerging Europe and we are, therefore, 'light' on Turkish assets at this point in time," says Plamen Monovski, chief investment officer of Renaissance Asset Managers.

The Turkish lira, fixed-income and equity markets have proved amongst the best performing assets in the world during 2010. In fact, the Turkish banks are the highest total return "country sector" in global emerging markets if you rank the performance of sectors within individual countries. Turkey's stock market is up 21% this year, compared with a 9% gain in the MSCI Emerging Markets Index of 21 developing countries, according to Bloomberg.

Analysts put the reason for this incredible performance down to an investing world that is, post-crisis, growth and yield-starved. A success story at a time of extraordinary economic turmoil, Turkey's growth this year has exceeded expectations, posting just shy of 11% real GDP growth in the first half of 2010. At the end of November, the European Commission lifted its forecast for Turkey's growth this year to 7.5% from an earlier projection of 4.7%. "In the relatively closed Turkish economy (much like in India), domestic consumption and fixed capital formation accounted for all of the GDP growth," says Monovski. "This was in sharp contrast with the rest of Europe and many parts of the world where growth was driven by inventory rebuild."

"Turkish growth stood out not only amongst the anaemic European 'growth' numbers, but showed a significantly higher quality," he adds.

The interest rate differential was the second reason for the appreciation in Turkey's markets, especially of the lira and the fixed-income market as the uncovered interest rate differential fell by 10% over the same period. Capital inflows surged, giving Turkey one of the largest absolute inflows of portfolio capital amongst emerging markets.

Not-so-hidden risks

Analysts say it's fairly easy to construct an argument why such appreciation should continue: the growth differentials are still there because of the demographic dividend of the country, the robustness of small and medium-sized business, the stability of the financial system and the smooth operation of the credit multiplier due to continued easy monetary conditions and the low aggregate leverage.

However, there's a host of issues keeping some investors like Monovski "light" on Turkish assets, not to mention the rating agencies cautious about upgrading the country, keeping it just below investment grade. In November, Fitch Ratings raised the outlook on its 'BB+' rating to positive, signalling that Turkey could soon reach investment-grade status, but it did so only grudgingly. "Fitch's move is important, as this suggests that the nirvana of investment grade is a real possibility for Turkey before the end of 2011," wrote Timothy Ash, head of emerging markets research at the Royal Bank of Scotland. "Moody's and S&P would then likely be dragged kicking and screaming to the party."

One of the main concerns centres on Turkey's low savings rate relative to its investment needs, which has resulted in persistent current account deficits. Turkey stands out with easily one of the highest current account deficits in the world, which is likely to gap up further to 7%. Turkey's current account deficit increased by 233% in the first nine months of 2010 when compared with the year-earlier period.

Domestic savings have fallen proportionally to the expansion in domestic credit volumes (Turkish banks had the highest lending growth in the world during 2010); falling by more than a third, savings are now below 10% of GDP. At the same time, the quality of the financing has deteriorated sharply. Foreign direct investment is down by more than 70% from its peak, mainly due to the weakness of Europe and the calming of the M&A fever for Turkish assets, so short-term flows - mainly debt - have underpinned the majority of the capital account movement. "This is somewhat disconcerting," says Monovski. "Flows can reverse as they have in the past. We can invent many reasons why they will do so: unexpected dollar strength, credit event in Europe, acceleration in core inflation are just a few excuses that come to mind."

Many economists say the Turkish central bank needs to start tightening interest rates; it actually announced an exit strategy from its "quanto easing" in April, but it has done nothing since then. "The [central bank] is caught in the same policy dilemma as many emerging markets banks, as it is loath to increase interest rates for fear of attracting more hot money," says Monovski.

There is also disappointment in many quarters over the Turkish government's failure to introduce a "fiscal rule", which aims to enforce cuts in public debt and the budget deficit, ahead of parliamentary elections scheduled for June 2011. In August, Standard and Poor's said the delay in implementing this "fiscal rule" implies pressure to spend in 2011, and points to rising external imbalances and a loose fiscal stance.

In the short term, investors are watching closely to see how Turkish markets perform in the face of the Eurozone's troubles. The EU is Turkey's primary trading partner. Turkish stocks tumbled as Ireland become the latest EU country to seek a financial bailout. "A contraction in European demand cannot be offset quickly," Gunduz Findıkcıoglu, chief economist of the Turkish Industry and Development Bank (TSKB) told the Hurriyet Daily News.

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