Economy strengthens but is it sustainable?
As expected, Q1 GDP growth is rather high at 5%. This is not unprecedented: the Q1 2016 print was also strong at 4.5% and Q2 2016 was even higher at 5.3%. But this time around there is consensus that the year-end print will be above 4%, and there has been at least one drastic revision from an international bank that now forecasts 4.6% growth by the end of the year. This is a massive revision since the previous estimate stood at 2.5%, and it reflects economic reality incomparably more accurately. Still, there are some concerns regarding the sustainability of this growth. Although such concerns are not unfounded, we do not think they pertain to the calendar year 2017. We now foresee at least 4-4.5% GDP growth this year. So let’s first take a brief look at the main drivers of the Q1 print.
Industry grew by 5.3% and services by 5.2%. Both were expected because growth in services, which comprises wholesale and retail trade, transport, storage, accommodation and food services, is easier to kick off through incentives that target the consumer. However, industry also performed well, notably on the basis of loans funded by the credit guarantee fund that skyrocketed in Q1. For this year-to-date, c. 180 billion lira has been used through that channel, whereas 250 billion lira is the limit. The disbursement of such funds peaked in the first two months, so Q2 will not be the same although lending continues even today. Seasonally- and calendar-adjusted GDP increased by 1.4% vis-à-vis Q4 2016, and that renders a particularly high rate if annualized. Calendar-adjusted year-on-year growth stood at 4.7%. The construction sector’s performance, at 3.7%, was weaker than the total average and agriculture posted 3.2% growth.
Capital formation unsatisfactory
On the expenditure side, public spending contributed plenty with final consumption expenditures hitting 9.4%. Household consumption, which is somehow always high, grew by 5.1%. There are two interesting figures here: gross capital formation and exports. Exports edged up by 10.6% whereas imports only by 0.8%. Capital formation grew much less at 2.2%. What do these two numbers tell us? Capital formation is not satisfactory, but after the referendum we tend to think investments picked up to a certain extent. We can see that for example from employment expectations, which are quite strong for Q3: 10 out of 11 sectors are optimistic regarding new jobs, and this strong view underlines growing confidence and rising risk appetite. Exports were extremely strong in Q1, and as such contributed more than 2% to growth. That is not the usual story, however, and probably we will revert back to normal in the following quarters, with the contribution of net exports flattening. Stability is key here. The exchange rate is and has always been crucial since Turkish corporates carry short positions and stability of any major price is also important. Hence, growing demand from export partners such as the Ger- many-driven EU and to some extent Russia, combined with stable currency and oil prices may have enlightened an otherwise rather dim export path. Even so, I do not believe net exports will deteriorate as I foresee only a gradual increase in imports. That panoramic view strengthens the case for GDP growth sustainability this year. Given the strong base effect in Q3, a GDP print of 4-4.5% is highly likely, with 4.5% as the point target. It all depends on Q4 since we will possibly come up with 4.5-5% growth in 9M 2017.
Tricky two years ahead
Enter sustainability. Again, there are two windows here. If we mean four quarters from now, the answer is probably yes. Growth is evidently based much more on public and household spending for the time being, with a joint contribution of 4.4% in Q1. Will it last? In the long run, it is not an easy thing to achieve since it will depend on whether loan growth momentum and public spending pace keep going. The government seems to think this is doable through a variety of devices. If elections are to be held in 2019, as scheduled, these devices will have to work for at least seven quarters from now.
Loan growth sustainability
Can loan growth be sustained for that long, perhaps not at the current rate, but still at a relatively strong pace? Let us look at banks. Swap volumes increased by a factor of c. 1.5 in Q2 relative to Q1, and that has had a bearing on overall funding costs. However, Eurobond and Tier-2 issuances, as well as syndications helped ease the burden. Now, we should remember that at the start of 2017 the main concern regarding loan growth sustainability came from that issue, i.e. rising funding costs
in a world where the Fed would hike further – which it did and will continue to do so – and the expected rating downgrade, which happened by the way with an initial 40 bps cost impact. Both negative incidents took place, but with no visible consequences. The credit guarantee fund played a huge role there, which caused a 123% increase in commercial and SME credits channelled through that device. Still, the loan-to-deposit ratio for lira credits reached 150%. Lira deposit rates went up to 15% as a result. Nevertheless, loan rates also went up and with the help of dividends, Q1 banking sector performance proved quite good. As expected, Borsa Istanbul (BIST) 100 recently hit 100.000. Even so, we cannot talk of a multiple expansion since Turkish banks trade at 0.9 PB and 6.1 PE, with 38% discount relative to emerging market (EM) peers. Although multiples stayed flat, stock prices went up because balance sheet and P&L developments shored up such an increase. Now, it all depends on the consequences of the Fed’s likely further hikes and the Central Bank’s future stance. If EM appetite goes on, even as the Fed continues to hike, the late liquidity window may be left to die off, and Turkish lira-denominated 10-year Treasuries could tend down towards 10%. This would cause a multiple expansion through the valuation discount rate. Oversold Turkish assets were in 2H 2016, and what we see is a partial recovery of that past movement, without multiple enhancement.
Stable lira plays its part
Lira stabilization within the 3.503.60 band in relation to the dollar has helped tremendously since banks do not carry short positions, but corporates do. It helped improve business sentiment, and also helped exports boom to some extent. Again, currency stabilization is key to everything here. Regarding asset quality, we have seen Non-performing Loan (NPL) sales albeit at a deeper discount – 5.5% rather than the previous 10% – but they can still be sold. For banks, the discount is not that important: what matters most is liquidity. So, a 3.2% NPL ratio is almost stable although it would have been above 4% without sales. Sales continue, and 3 billion lira NPLs have already been sold yearto-date. That is small compared to balance sheets, but they help at the margin. Loan reserve requirement ratios have been lowered, and that also rather helped. As for the guaranteed loans that grew at breakneck speed in Q1, they are mostly 1-2 years maturity. The impact on asset quality will not be visible before Q2 2018 at the earliest.
In short, if EM appetite endures a banking system with a 3.2% NPL ratio and reduced requirement ratios, 16.4% capital adequacy ratio, with a prospect for multiple expansion in valuations, one could easily ink in 16% Return on Average Equity (ROAE) and 22% asset growth in 12 months’ time. If FX-loans are to be securitized with the state acting as leader and sold overseas, especially project finance and large corporate loans, there will be plenty of room and liquidity ahead. That is, unless things turn upside down and EMs are screened with a fine-grained lens as a result of both the Fed and ECB’s balance sheet contractions that lay ahead. This is my main concern since rate hikes are predicted, but a combined balance sheet/interest rate sea-change might have a large impact on pricing for EM assets of all sorts. Otherwise, the banking system may keep going at high speed as it is for at least the next year. We should also keep in mind that 85% of loans disbursed through the credit guarantee fund are covered by the state. This is important since the advent of IFRS-9 will reduce the leeway provided by the regulator in terms of loan reserve requirements.
Monetary policy not behind growth
The Treasury has borrowed at high ratios. Nevertheless, in the short run that could be good as it provides liquidity to the bond market. May 2017 budget figures showcase a positive development, but for the first five months the deficit is 11 trillion lira. That may go on for yet another while but not forever. We do not see that as a crucial concern though, as we consider a rather considerable slack on that front. Alternatively, the Central Bank’s recent no-change policy looks admissible especially given that growth is high and there is a net exports component in it. The exchange rate is clearly compet- itive as shown by the graph that depicts historical data. In other words, at 3.50 to the dollar, the lira is still cheap in a sense. Monetary policy is rather flexible in a nice sort of way. What this means is the central bank doesn’t have to change the policy rate since the average funding rate – at c. 12% is tight – and the late liquidity rate – 12.25% – is high. The central bank can always change the weights of the funding mix and lower its average funding rate without touching any of the particular interest rates. It makes sense to assume that, if inflation trends down to below 10%, the bank will seize this opportunity to lower the late liquidity rate, but even without doing so it has the flexibility to adjust the effective rate down. We should note that at lira deposit rates hitting 15%, loan rates at around 1718%, and the average funding rate at 12%, there is still 5% GDP and 10.6% export growth. We might also remember that in the previous monetary policy committee meeting of the central bank, the average funding rate was barely around 11.5%. Hence, since mid-April the monetary policy stance was clearly tight, and that tightness controlled the exchange and to some extent the inflation rates. Growth stimuli did not come from monetary policy, but from the credit guarantee fund, from the regulator’s bank-friendly stance and from public spending.
With the end of the currency passthrough and lower food prices, as inflation recedes down to below 10%, which is more likely than not to happen this year although for most of the year low double-digit inflation will be persistent, the central bank may find an opportunity to fine-tune its stance and loosen a little. So, this is the view now: 4-4.5% GDP growth, 9-10% CPI, slightly lower funding/loan/deposit rates, 16-17% ROAE and CAR, 22-23% asset growth. Not bad, huh?