CEE & Turkey

Turkey Represents a Big and Difficult Call for Emerging Market Investors This Year

There are good reasons to be cautious around Turkey this year, given well-known concerns over security and domestic political stability exacerbated by polarisation as we head towards the scheduled referendum over the introduction of an Executive Presidency. Turkey’s well known Achilles heel, large external financing requirements (around US$200bn, double the country’s foreign exchange reserves), and associated concerns over rollover risks on around US$160bn in short-term debt liabilities, has not been helped by the recent sharp exchange rate drops or less-than-orthodox monetary policies from the CBRT, which are considered “opaque” by many.

That said, Turkish assets on many matrices appear cheap relative to peers and the historical Turkish context.

The lira does not look expensive, and is indeed close to 2003 levels from a real effective exchange rate perspective. Turkey has its problems, but there have been so many positive changes since 2003, including a two-thirds cut in the public sector debt ratio, a stronger banking system after the reforms instigated after the 2000/01 crisis, along with further liberalisation and privatisation over the past decade. Turkey is a much more vibrant and durable economy than it was in 2003, and perhaps this is being reflected in the resilience of Turkish banks, business, and public finances.

Most investors reduced exposure during recent periods of heightened political/security noise, seen in the weekly flow data of TRY fixed income holdings: net outflows of over US$3bn in lira-denominated government debt securities since the July 2016 coup attempt. The stock is now at a six-year low.

Many investors now seem to be on the side-lines, seeing value and looking to buy, but looking for a signal. The hope was that the CBRT would make their lives easier by hiking policy rates in a more convincing and permanent way than through its current “dynamic tightening” and use of the by nature temporary late liquidity window.

Instead it has muddled the move and the decision for investors with its usual smoke and mirrors approach to monetary policy. That said, what is clear from the roughly 300bp in tightening since January, is that the CBRT wants to anchor the currency at least through the April 16 referendum.

Credit quality is still generally strong. The willingness to pay is high and NPLs are low, public finances remain strong, and the country still benefits from favourable demographics and decent underlying growth drivers.

The move to an Executive Presidency is already priced in. The assumption is that Erdogan will win the vote, and that once he ‘de jure’ takes the role of president, he will have an interest in moving away from a polarising agenda, and will want to go back to delivering what the AKP arguably does best: delivering on growth, jobs, and improving standards of living for ordinary Turks.

Let's hope. But there are widespread and justifiable concerns over the form of an Executive Presidency being rolled out in Turkey, and questions on whether there are sufficient checks and balances contained in the new constitution. Turks will have the chance to weigh this up themselves.

These concerns are well grounded, especially given the erosion of institutional strength in Turkey over recent years – not helped by events in the run up to, and aftermath of, the July 2016 coup attempt – and highlighted by global rating agencies. This will likely weigh on long term growth, which is likely to be lower than its potential.

Turkey’s mode of development is undoubtedly shifting to an Asiatic model that sees a stronger centralised system with a dominant single party. This works in many Asian countries, albeit key to success is the idea of adequate checks and balances, and the application of the rule of law. Singapore is a good example of where this model is succeeding, but there are many examples of less successful models – Russia – and the question is: where will Turkey will sit on this spectrum?

A Cyprus peace deal is possible, which would be somewhat unexpected but would break a logjam in relations with the EU. It would create a significant feel good factor around the region, and could open up lots of new opportunities for Turkey in the energy field. The current spat between Greece and Turkey over the extradition of a number of Turkish army officers who defected after the July 2016 coup attempt, does complicate matters.

A Turkey-EU migrant deal, against the odds and expectations of most analysts, has remained in place and is working, at least from the EU's perspective. What has been made clear from this, and the recent visits of PM May and Chancellor Merkel to Ankara, is that despite strained EU relations, it remains of key strategic interest for the EU to stay engaged with Turkey and not to fully cast off the EU accession process.

The EU will remain a key anchor for Turkey, a type of check and balance, however moderate on the Erdogan's regime. The regime still needs the EU accession angle as a selling point for investors, while the EU remains an increasingly important market for Turkish goods, as laid bare recently by difficulties in trading with Russia and the Middle East.

A Trump presidency is likely positive for Erdogan, as both are “deal makers”. Relations between the Erdogan and Obama administrations were at a low point following the July 2016 coup attempt, with Turkish suspicions of US “complicity” agitating the situation. Surely, relations cannot get any worse under Trump. Both leaders see themselves as strong men, and the Trump administration likely sees Turkey as an ally again in a bigger tussle with Iran.

The current account deficit (at 4-5%) still and large external financing gap (at approximately US$200bn) remains an Achilles heel for Turkey, especially in an environment where the Fed is likely to continue tightening. Most economists expect the Turkish economy to slow this year on the back of monetary policy tightening, with concerns over domestic politics and security cooling import demand.

A much weaker lira should help adjust the current account lower, albeit noting the countervailing impact of the loss of key tourism receipts and higher energy prices. It is important to highlight the favourable structure for short term external debt, including the weight of trade finance, inter-company loans, and offshore Turkish lending back into Turkey.

Rollover ratios have remained elevated, as they did during the 2000/01 and 2008/09 crises. Turkish banks and corporates are affected, but through P&L in having to pay more to rollover, but we are still a long way from a credit event/crisis in Turkey.

Security is certainly a major issue, with challenges still being felt from the 2016 coup attempt and subsequent purge, insecurity emanating from Iraq and also Syria, ISIS, and the Kurdish conflict. Turkey is clearly located in a difficult neighbourhood, but the multiple threats currently facing it are materially more significant than at any time for several decades.

The imposition of a state of emergency was understandable, but its prolongation is un-nerving investors, and the fear is that counter terrorism measures are not adequately honed, and that basic freedoms are being reined in with an impact on checks and balances; ultimately, the risk is bad policy outcomes.

The hope is, once Erdogan's assumes the executive presidency, efforts will be made to return to the Kurdish peace process - which seems inevitable, and that recent diplomatic efforts will scale back the threats from both Iraq and Syria. That said, the threat from ISIS in both Syria and Iraq, and the intractability of the conflicts in both countries suggests this will be a very tall challenge. Perhaps the best that can be achieved is for Turkey to not be dragged further into those conflicts.

On the macro front, Turkish story could easily turn around if we see a more orthodox and investor friendly approach from the government and the CBRT. Monetary policy lacks credibility, coherence and transparency, and while the CBRT has tightened policy via a “dynamic” and multiple rate approach, the use of the late liquidity window to tighten leaves an impression that this is grudging and temporary, and that the bank is not that serious about fighting inflation. Its recent dismal track record in meeting its inflation targets says it all - five straight years of failure therein. The latest (February print) of 10.13%, close to double the target, says it all.

The concern clearly is that the CBRT is constrained by the political setting and an aversion to interest and usury. Fighting the market and investors rarely ends well for policymakers, and a better approach would be to work with the market to secure optimal outcomes. I think if the CBRT listened more and acted more pre-emptively, ultimately the extent of hiking and impact on growth would be much more limited.

Turkey's loss of full IG status is disappointing, but the way the market has taken this in its stride is encouraging, and reflects the fact that it was to a great extent priced in. Arguably, with these downgrades, an uncertainty has been removed and Turkey can now move on. Officials carping back at rating agencies for the downgrades is hardly helpful – it is counterproductive. Better would be to listen to the concerns of the rating agencies, and adjust policy to address those and the concerns of investors alike.

Overall, I remain constructive on the longer-term Turkey story, albeit sometimes near-term volatility and noise test one’s resolve in holding to this view. I would highlight strong public finances and banks, favourable demographics, entrepreneurial pro-business culture across society and still entrenched in the AKP government, and diversified trade, adding in now a very competitive currency, with the EU accession anchor still hanging by a thread, however worn.

The hope is that once the outcome of the referendum is set that the Erdogan administration will have a strong interest in betting back to business, quite literally. This should hopefully mean efforts to calm the domestic political and security scene and hopefully also move to rebuild relations with traditional allies.

CEE & Turkey

Tim is currently an emerging market sovereign strategist at BlueBay Asset Management, working in the emerging market debt team. Tim was previously Head of CEEMEA Credit Strategy at Nomura. He has also previously held positions as Head of EM Research at ICBC-Standard Bank, Royal Bank of Scotland and Bear Sterns.