The other rea­son to avoid Turkey

Financial Mirror (Cyprus) - - FRONT PAGE -

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.

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