Ben Aris in Istanbul -

"For the last five years, the Turkish market was performing very well and it was an easy story to sell," says Ozgur Altug, chief economist with Raymond James in Istanbul. "Now, growth is down, inflation is up, privatisation is frozen by a political crisis and equity inflows have reversed. I don't have anything left in my hand to sell."

The mood in Istanbul is glum. Turkey's rapid growth has suddenly stalled as the country was struck by nasty macroeconomic problems and a political crisis just as the external shock from the US sub-prime mortgage hit.

The silver lining is that a few years ago this triple whammy would have been enough to spark a major financial crisis, but now the worst that analysts are expecting is a difficult two years of low growth. Still, that is little compensation for investors who have been enjoying strong growth and fat returns for years. Equity investors can still look forward to perhaps 25% of growth in share prices this year, but this will be among the lowest in emerging markets - if it comes at all.

Damp squib

Ankara was all revved up for a party in March when it finally revised its methodology for calculating GDP. The previous one was 20 years old and didn't take in all the "new economy" business activity in sectors like services. The result was the Turkish economy increased in size by a third overnight. According to official figures released on March 8, Turkey's GDP was TRY758bn ($606bn) in 2006, a 31.6% rise on the previous estimate of TRY576bn and per capita income for that year was raised sharply, from $5,480 to nearly $7,500.

Normally, this kind of step-up in the numbers would have triggered an automatic upgrade for the sovereign ratings by the international rating agencies. Not in Turkey's case. The mounting macroeconomic problems coupled with the atrocious conditions on the international debt markets led Standard & Poor's to downgrade Turkey's rating outlook to 'negative' from 'stable' on April 3.

Turkey is grappling with two nasty problems, neither of which are easy to solve. The first is a long-running political crisis that blew up again at the end of March. The other is a gaping hole in Turkey's current account, which economist say is likely to hit a record high this year of about $48bn, or 6% of GDP. It looks almost certain that the government won't be able to fund this deficit. Both problems mean Turkey is out of the race for at least one, maybe two, years.

The current political crisis erupted on March 31 after a top court decided to hear a case calling for the banning of the ruling AKP for being "anti-secular." The mildly Islamist party is suddenly fighting for its life and now looks unlikely to have the time or inclination for reforms aimed at strengthening the country's still-flawed democracy and advancing its bid for EU membership. "We can't move forward until this court case is resolved, which will take between six and 10 months to do. In the meantime, all the legislative work is on hold," says Haluk Burumcekci, senior vice president at Fortis Bank in Istanbul.

The outcome of the current political crisis is difficult to predict. The constitutional court surprised most foreign investors by agreeing to consider the case in the first place. Many pundits in Turkey think that the AKP will be banned, but are not sure if this will make a difference in practice. "There are only 70 members of the party accused of anti-secularism, of which 40 are MPs from a total of 340 in the party. If these members are banned, then all that will happen is it will trigger a general election in which the "BK Party" will stand - or whatever letters they choose - win 320 seats and be back in power," says Yurdal Yalman, assistant general manager at Oyak Securities.

Slightly worse scenarios include AKP attempting to change the constitution to prevent this sort of case being brought in the first place. One option here is to ally with the rightwing nationalist Republican People's Party (CHP), as one of the AKP's few potential allies. "This alliance would upset the secularist lobby even more," says one banker who didn't want to be named. "There is little chance of seeing tanks on the street as in the 1960s, as there is no popular support for military intervention anymore, but this scenario would be even messier."

However this dispute plays out, all are agreed that it's a bad time to be distracting the government from its main job - passing laws. Encouraging foreign investment - both portfolio and direct - is key if the gap in the current account deficit is to be closed, but important items on the docket, such as a badly needed social services reform bill or big privatisations, are likely to be delayed for at least a year, not to mention the damage the uncertainly does to the investment climate in general. "Normally, the media and business would have supported the social system reforms, but in the current climate the AK Party is struggling to find any support at all and this will certainly delay the reform agenda, which will have long-term consequences for Turkey's development," says Burumcekci.

Money sources

Turkey has three main sources of money to cover its current account deficit: foreign and portfolio investment, privatisation, and foreign borrowing. All three are in bad shape.

Equity investment stalled at the start of this year. Analysts estimate that some $850m has left the stock market in the first two months of this year following $4bn-5bn of inflows in 2007. Bond inflows have likewise dropped to zero. Foreign investors hold an estimated 69% of the freely traded shares on the Istanbul Stock Exchange and bond investors about 16% of the total outstanding bond stock. Turkey's is the worst performing major equity in the global emerging market universe, down over 30% since the start of the year. Oyak Securities has slashed its year-end target by 20% for the index, but says there is still 25% potential upside left. "The trouble is that 25% for emerging market investors is not very exciting," says Oyak's Yalman. "If you have Eurobonds now earning 7-8%, then the difference is not enough given the risk profile."

Foreign direct investment has been pouring into Turkey and is the least likely to be affected by the current brouhaha. Multinationals are focused on a consumer-spending boom being fed by a growing population - a long-term story as opposed to the short- to medium-term prospects of the current crisis. Still, analysts say FDI will probably slow somewhat this year from the $20bn invested in 2007 to $16bn-18bn (Raymond James recently revised its FDI forecast down from $23bn) although the government's official forecast still calls for $20bn of FDI in 2008. The privatisations slated for this year would have helped, but none are expected to happen now. The sale of a 75% stake in state-owned Halk Bank would have brought in $10bn, but no one is expecting this to happen until at least 2009, if not 2010. Likewise, the IPO of leading fixed-line phone firm Turk Telekom slated for May, which could have brought in $2bn-3bn, is also unlikely to happen.

One of Turkey's big selling points is that it had the highest interest rates on bonds and bank deposits among emerging markets. Extra-high interest rates are not really something to boast about, but at least it had the merit of making issuing bonds easy. But even this advantage is being eaten away - not to mention the poor state of the international credit markets. Official figures suggest that Turkish non-financial companies will have to roll over $22bn of loans this year. Just refinancing this amount will be hard, let alone raising fresh capital. "We had high interest rates, but the other markets are now increasing their rates while the returns here are falling. The gap is getting smaller and eating into our niche," says Altug.

Borrowing is made more problematic by large Turkish companies having made active use of foreign credit markets. They will have to refinance some $22bn this year and need to come up with about $26bn in total in very difficult market conditions. "This might be dangerous if these companies don't have foreign currency revenues to cover the borrowing. However, most of Turkey's big companies are export orientated so there is a natural hedge. At the same time, their owners almost all have large reserves of foreign currency. The only danger with this is that you have to trust that they will use this money to bail their companies out if they get into trouble," says Burumcekci.

Raymond James' Altug says do the math: assuming FDI of $20bn, privatisation of $10bn and that Turkish companies can at least refinance their previous borrowing (all of which are admittedly optimistic), then this still leaves the government short some $18bn to cover the current account deficit. Tourism may go some way to making up the difference, as Turkey is expected to earn $15bn from holidaymakers this year, but it's going to be a tense year and what the outcome will be remains far from clear. "We will probably fail to cover the current account deficit this year. The central bank will loose some of its reserves - some $5bn-6bn is likely - so the currency will weaken," says Altug. "But this is not a crisis. The central bank has $75bn in reserves, so it can easily cover the short fall. This will be a correction and no more."

There are a few mitigating factors that will cushion the blow. Chief among them is the central bank's hard currency reserves. And thanks to the instability of the local currency, the general population has also built up an estimated $95bn in hard currency savings, which have been losing value as the dollar tanks on international exchange markets. Many are looking for a chance to sell their dollars, which acts as a natural hedge: if the Turkish lira falls hard against the dollar, the population will sell their dollars to take advantage of the improved exchange rate and act as a brake on the fall.

Likewise, the banking sector is much healthier than it was 10 years ago, making another banking crisis very unlikely. In 2000, banks had $10bn foreign currency exposure to international lenders that was equivalent of about 5% of GDP. Following a tightening of borrowing rules after the 2001 crisis, banks have reduced this exposure to some $1bn now, or about 0.3% of GDP - a more than manageable amount. "A collapse of the bank sector is very unlikely now. In 2001, the banks had large exposure to foreign borrowing, but since the crisis the central bank has been much tougher with regulation and they all have small positions now. The bank sector is not vulnerable," says Fortis' Burumcekci.

Stagflation

The upshot is that the Turkish economic growth is likely to slow sharply this year and things will be hard for the next two years. The economy already slowed to about 4.5% in 2007 and economists predict this year will see a similar rate of growth. "The majority of the Turkish population is under 30 year of age. Growth at less than 5% a year will cause problems, as there is a demographic pressure that needs growth of at least 5% just to keep creating enough jobs for those looking for work," says Burumcekci.

At the same time Turkey, like all of the other countries in the region, is battling rising inflation. The main culprit is escalating food prices, which make up 35% of the Turkish CPI basket. Rents have also been rising, by 15% in 2007, which hits the whole population. The result is inflation has risen from about 7% in 2007 to an annualised 9.1% over the first quarter of this year. "It will almost certainly go into double digits this year. Under the terms of our standby agreement with the IMF, we have to hit quarterly inflation targets, which turkey will now miss. The rising inflation means that the central bank can't cut rates anymore which also needs to happen," says Altug.

The situation will be made more complicated, as the deal with the IMF is due to expire in May and no new deal has yet been agreed; if no compromise is found then investors' confidence will be eroded further. "For this year and next year, the downside risk is very high," says Burumcekci. "The next few years will be very difficult as we are looking at low growth and high inflation. It is a very dangerous cocktail."

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