Tim Ash answers FAQ about Turkey

Q: Turkey is a big EM credit, what is the foreign investor view of the story?

Answer: Historically yes it has been a big, liquid EM market covering credit/hard currency debt, local rates, FX and equity. If you were in EM, you had to invest/trade in Turkey, and you had to understand, or try to understand, the story. Most EM investors spent a lot of time visiting Turkey, talking and thinking about Turkey. If I think of my research I would visit Turkey as often as I could, perhaps half a dozen times a year – albeit I never needed an excuse to visit Turkey, it’s absolutely at the top of my list of favourite countries.

I think the above is changing a bit – not my love of the country. Indeed, as the Erdogan government tries to micro manage markets, it is becoming more difficult to trade and invest in Turkey – at least for foreign portfolio investors. And this is despite the fact that on many accounts Turkish assets scream or suggest “value”.

If you think of that value proposition, Turkey offers double digit nominal local rates, for a country still having a strong public finance profile – the budget deficit is still only 4-5% of GDP despite Covid19 related widening, and the public sector debt/GDP ratio is only around 30-35%, with a current account deficit of likely around 1-2% of GDP this year. These ratios are the envy of many Emerging Market and even many a Developed Market economy -the debt ratio is around one third of the EU average, and half the EM average. The banking sector is generally strong/solid, with decent capital buffers, modest NPLs, decent growth potential (given Turkey has a young population and is generally thought to be underbanked) and good risk management. Foreign and state ownership in the sector is relatively high which provides an additional buffer/assurance. The country also still has favourable demographics, it benefits from a good location (between big markets in Europe, the CIS and the Middle East) and should be a net winner post Covid19 from pressure to diversify global supply chains away from China as it has a strong manufacturing tradition, skilled labour and good middle management. Its pro-business, pro-market, low tax environment for foreign business. It has had good growth drivers – as reflected in what seems at present to be a V-shaped bounce back from Covid-19 related economic disruption.

In terms of credit Turkey offers a decent carry on par/even higher with the likes of credits which arguably have much weaker ratios – think therein Kenya, Egypt, South Africa, Jordan, Jamaica and Costa Rica.

And yet despite all the above, investors are still hanging back from investing in Turkey – indeed, they continue to reduce exposure to Turkish local markets. Therein the stock of foreigners now in the local debt market is around one-fifth of its peak (around USD7bn at present), and debt and equity portfolio outflows have continued this year to the tune of over USS11bn. What is remarkable about the latter also is that this has been in an environment of monetary policy easing which would normally entice hot money inflows from foreign bond investors – indeed in any other year over the past 20 years when policy rates would have collapsed by 1000bps plus I think Turkey might have expected $10-20bn in portfolio inflows.

Explanations as to why foreign investor are holding back are numerous, and within that are geopolitical concerns around the orientation of the Erdogan administration, but I think at the core is concern around the macro policy mix and central therein is monetary policy.

And herein nominal rates might be 8.65% to 12.5%, but inflation came in at 12.6% in June, so nominal rates are either close to zero of significantly negative, albeit depending on whether you prefer to use ex-poste or ex ante inflation as your benchmark. The CBRT’s track record on inflation is dire – having only met their inflation target once in the last ten years and that is in a world where deflation has been the watchword – so it’s hard to use ex-ante forecasts with any confidence. Sure, we are operating in a world of global deflation, with big output gaps post Covid-19, but the Erdogan administration is pump priming growth through the credit channel aggressively, with 30-50% YOY rates of credit growth, and Turkey seems to be something of an odd one out, or exception, in this global deflation theme. There just does not appear to be enough real carry, to entice foreigners into the trade, and therein also perhaps locals, given continued dollarization in terms of local deposits, which remain close to record highs at around the USD200bn level. The fact that neither foreign portfolio investors not local retail/corporate depositors want to hold lira is quite telling.

At the heart of the problem is the political economy. And economic policy is Turkey is driven by the political and electoral cycle – and the Erdogan administration is almost always in election mode. It always feels the need to deliver growth to create jobs and the feeling of prosperity to underpin its electoral support. And historically growth has been driven by credit – and lots of it – and most of this has been foreign funded. But what is changing now is the CBRT has figured out the wheeze of funding this credit growth by utilising domestic FX savings in the form of the weight of FX deposits in the banking system.

The CBRT and Turkish policy makers seem to think they can use smoke and mirrors to deceive when it comes to the impossible trinity to deliver a stable currency, high growth and low inflation. Their version of it is the “wheeze” of recycling the large/rising stock of local FX deposits, through state owned banks to defend and anchor the exchange rate, sufficient to allow them to cut policy rates to spur high real GDP growth and a political dividend at the polls to the ruling AKP administration. But while growth might be rebounding, high and sticky inflation is a reflection of the fact that the policy is not really working, and continued dollarization and capital flight by foreign portfolio investors is evidence of this. Evidently neither local deposit holders nor foreign portfolio investors think the carry is enough to compensate for inflation and ultimately exchange rate risks. And frankly few people believe that the CBRT has discovered macro nirvana on the impossible trinity through the recycling of FX deposits – whether this is hidden through a technicality of how these swap transactions are recorded on the CBRT balance sheet, the reality is clear to most objective economists that the CBRT is spending other peoples’ money.

Those other people are depositors. And it is true that gross reserves are really all that matters from a central bank FX management perspective, or they are all that matters until they don’t – as recent experience in Lebanon reveals. It has to be deeply troubling that while the CBRT has been able to keep headline gross FX reserves more or less unchanged this year, its net position has deteriorated to the tune of anywhere from USD22-50bn, again depending on how swap transactions are accounted for. The question is how long people remain sanguine over the deterioration in the CBRT’s net reserve position, and begin to question whether this is a risk to the solvency of the CBRT, but also the banking sector more generally. As Lebanon proved, this strategy can last many years, even decades, but when the music stops the FX mismatches have to paid by someone, and in Lebanon’s case it is now mostly being borne by depositors.

So inflation is in double digits and sticky, the government continues to pump prime growth, which will feed a larger current account deficit, bringing a larger external financing requirement. This is being masked by the fun and games in the use/accounting of net reserves – it is being funded through spending the FX deposit base. But eventually the music will stop, and something will have to give again, in a repeat of 2018. Either the FX will have to adjust weaker, or policy rates will have to go higher to slow domestic demand and import demand with it. It is possible though with foreigners largely out of the market that this CBRT wheeze could last all year, and well through 2021. I guess the experience from 2018 is that we know the bubble will burst and its better for the CBRT to deflate it slowly through the neck using rates, but because of the political setting and Erdogan’s aversion to interest rates and usury, the balloon is more likely to be overinflated to bursting point, rather than gradually let down. Cleaning up the mess is then a much more difficult affair.

Net-net, because of all the above foreign investors just don’t feel comfortable in vesting in the story. They are convinced the bubble will burst, but just do not know when, so would rather stay on the side-lines. And there is just not enough confidence in the CBRT that they will be willing or able to do the right thing at the right time to slowly deflate the bubble.

Q? How is Turkey coping with Covid19

Answer – probably much better than either the US or the UK. Unlike these two other countries the top level government response has been much stronger, better coordinated, and ultimately more effective. And maybe there is something cultural going on in that Turks seem more willing to follow rules and orders from government in terms of social distancing and the wearing of face masks – I know in the UK, the public response has been disappointing frankly if the 5% or so of people wearing face masks on the streets of London is anything to go by. Recent large scale investment in the health sector has also put Turkey in a relatively strong position – it compares very favourably to the EU average in terms of ICU beds available.

Activity is returning relatively quickly – and Turks have that ability to bounce back, its in their nature, maybe helped by its young, dynamic population.

But the loss of the USD30bn tourism business, at least for this year is a real blow. It’s hard to see this business coming back quickly at least for this season. And obviously this puts added pressure on the BOP, and the exchange rate.

Q? So what about the geopolitical setting?

There is always a lot of geopolitical noise in Turkey – we can think here of strained relations with the West over migrants, the situation in the Eastern med, the Gulen issue, the Kurdish issue, Western perceptions that democracy and human rights are under threat from the Erdogan administration, Russia (S400s), Iran sanctions busting (the Halkbank issue) and Syria, amongst others – including lately the planned conversion of the Hagia Sophia museum to a Mosque. Relations are also strained with some Gulf states (Saudi Arabia, the UAE) and Egypt over Turkey’s support for political Islam, latterly in Libya. And more recently the warming in relations with Russia has gone into reversal as tensions also emerge over Syria, Libya and now the Hagia Sophia mosque issue also.

It is probably fair to say that on some levels relations with the US and the EU are the worst they have been in a decade or more. And yet despite all that – and plenty of talk of imminent sanctions being imposed on Turkey by the US for the Halkbank issue and S400s – the West has done little in effect to sanction the Erdogan administration. Some might argue that Erdogan has played the West well, and in particular he has utilised the seemingly strong personal bond between Erdogan and Trump, and the two respective first families, to counter sanctions pressure from the DC establishment. Similarly, with regards to the EU, Erdogan seems to have read well that the EU needs Turkey more than the other way around on issues such as NATO defence (Turkey still has the second largest standing army in NATO) migrants, Syria, Libya and fighting Islamic terrorism.

True, the West still accounts for some two thirds of Turkey’s trade, financing and foreign investment flows, but any sanction on this business will hurt Western business just as much as those in Turkey. So in the end, the West is having to learn to manage the relationship with the Erdogan administration – trying to manage it to limit the downside in the hope of perhaps some future change. The two sides are kind of treading water or buying time.

Perhaps the biggest risk to the above comes from looming US elections – the Erdogan administration has invested a lot in the relationship with Trump and his family. A Biden win would remove an important foil against pressure from the DC establishment for sanctions against Turkey on issues such as Halkbank and S400s. But even then, the reality is that Turkey is a key strategic ally of the West, in a difficult location, and pushing an aggressive sanctions regime against the Erdogan administration would risk pushing Turkey further into the arms of the West’s foes in Russia and Iran. More likely a future Biden administration will attempt a reset with the Erdogan administration, at least in the first instance.

Q: Do geopolitics matter for investors?

Answer – absolutely, if the risk is of sanctions on Turkey, but as I have noted above, this seems unlikely at this stage. But I think strained relations with the West does have an impact on investment – whether that is foreign portfolio or direct investment. And herein I think it is not by chance that foreign direct investment is running close to 20 year lows – and I think you can chart the decline therein from the peak of 2006/07 when Turkey was on a track to EU membership, and benefitting from a near honey moon in relations with the West, to the period since when relations with the West have been on a trend towards deterioration.

All the above is incredibly sad as Turkey is a great country, with huge potential and problems that actually could be relatively easily solved with relatively modest changes, particularly I would argue in the sphere of monetary policy, and with a little better mood music in terms of the relationship with the West – and I think it is important herein that there has been fault on both sides.

** Please note that any views expressed herein are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions. The views expressed do not reflect the opinions of all portfolio managers at BlueBay, or the views of the firm as a whole. In addition, these conclusions are speculative in nature, may not come to pass and are not intended to predict the future of any specific investment. No representation or warranty can be given with respect to the accuracy or completeness of the information. Charts and graphs provided herein are for illustrative purposes only.

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Published By: Atilla Yeşilada

GlobalSource Partners’ Turkey Country Analyst Atilla Yesilada is the country’s leading political analyst and commentator. He is known throughout the finance and political science world for his thorough and outspoken coverage of Turkey’s political and financial developments. In addition to his extensive writing schedule, he is often called upon to provide his political expertise on major radio and television channels. Based in Istanbul, Atilla is co-founder of the information platform Istanbul Analytics and is one of GlobalSource’s local partners in Turkey. In addition to his consulting work and speaking engagements throughout the US, Europe and the Middle East, he writes regular columns for Turkey’s leading financial websites VATAN and www.paraanaliz.com and has contributed to the financial daily Referans and the liberal daily Radikal.