The other reason to avoid Turkey
Investors had long priced in the risk that the ruling AK Party of Turkey’s Recep Tayyip Erdogan could win a two-thirds majority in last Sunday’s parliamentary election, a result that would have allowed the president to reinforce his constitutional powers at the expense of parliament. What they failed to price in was the risk that the AKP could fail even to win a simple majority. In the event, that is exactly what happened, leaving Turkey facing the arduous — even impossible — task of cobbling together a coalition government involving at least one of three fractious opposition parties. In response to the heightened uncertainty, Turkey’s benchmark stock index fell -5% on Monday, while the lira slumped -3% against the US dollar to leave it down -15% over the year to date.
Erdogan’s failure to capture a simple parliamentary majority is not all bad. International investors are likely to cheer the burial — at least for the time being — of his authoritarian constitutional ambitions. And they will certainly be relieved to see the end of his attempts to undermine the independence of Turkey’s central bank. But even if Turkey can manage to form a government over the next six weeks, dampening short term uncertainties, there will still be solid reasons why, despite superficially attractive valuations, investors should steer well clear of Turkish assets.
According to the latest available data, Turkey still shows up very clearly as a “weak link” on our in-house Emerging Market Vulnerability Index, ranking in the bottom third of 18 major emerging markets by 12 different measures. What’s more, Turkey’s vulnerability is especially acute if we focus on its external financial position. Even though Turkey is a major oil importer which has benefited from the -43% decline in oil prices over the last 12 months, its current account deficit—at 6% of GDP in 2014, and 7.5% in 4Q2014—remains among the biggest in the emerging market universe.
On the capital account side, Turkey’s banking system is heavily dependent on foreign inflows. Since the financial crisis, Turkish commercial banks have ceased to balance their foreign exchange positions, allowing foreign currency liabilities to climb to 20% of their balance sheet. From a relatively well-managed position in 2007, Turkey’s banking system now has the worst foreign exchange mismatch in the emerging market universe. If the economy of Korea, a net foreign creditor, suffered from a run-up in foreign currency borrowing by local banks in 2008, how much greater is the damage likely to be inflicted on Turkey?
Much of this foreign currency borrowing has been channelled into strong consumer credit growth, with domestic credit expanding at more than 20% YoY so far in 2015, far in advance of domestic deposit growth. In other words, banks have borrowed abroad to fund domestic consumption, which leaves the resilience of Turkey’s domestic demand looking largely illusory.
In theory, the situation is not beyond redemption. With a decisive central bank, in 2013 India hiked interest rates to halt its currency devaluation, while restricting gold imports to reverse its deteriorating current account. Meanwhile, the government won over foreign investors by committing to structural reforms. But the turnaround required strong and proactive government, which Turkey lacks after Sunday’s indecisive election. If the lira were to fall further, another potential way out for Turkey could be through stronger exports, as with Korea in 2008. However, Turkey’s weak export base means any immediate boost to shipments from lira undervaluation would be limited.
As a result, Turkey’s asset prices and growth outlook are both extremely vulnerable to capital outflows. To overcome the vulnerability and end the vicious cycle of outflows, Turkey has little option but to endure the pain of a contraction in both domestic credit and economic growth in order to steer its current account balance onto a more sustainable trajectory.