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I visited Istanbul and Ankara on 18-20 February, meeting with various government officials, attending the latest CBRT meeting with economists and meeting a number of diplomats, journalists, analysts and bankers.
Markets have discounted political risk, but the ongoing pressure for constitutional reform could create hurdles on the way, and prospects of a looming referendum creates the risk of policy mis-steps ahead. Regional political risks are also set to continue to fester, creating contingent risks which cannot be entirely ignored from a market perspective.
Watch out for an FATF ruling next week which might still spring surprises and could still cause difficulties for the domestic banking sector. The CBRT remains confident of the growth/recovery story and is indicating a willingness to continue to tighter policy through the use of macro prudential tools. We are less convinced over the success of efforts to stem hot money inflows, and with the current account deficit set to re-expand in 2013, we think the risks of an exchange rate correction are significant. Indeed, we have revised up our exchange rate forecast for year-end, to TRY1.9 to the US dollar. The risks are now biased to the downside, and with local currency debt only yielding 5.75% or thereabouts, simply put, investors are not being paid for the risks. With growth recovering and with prospects of the lira cheapening, it probably makes sense to move out of bonds into equities, which also benefit still from the very positive longer-term story on Turkey.
Markets have long discounted political risk in Turkey, and the debate during our visit surrounded what, if any, of the political issues/challenges facing the country could have any market/marked impact.
Domestic politics - constitutional reform, and the Kurdish reform agenda
The domestic political scene is currently being dominated by discussions over plans for constitutional reform. Currently, a parliamentary constitutional reform commission is trying to win cross party support for a single document, to replace the 80s era constitution borne out of a military coup, and which has only been partially reformed/updated since. The consensus is that prime minister Recep Tayip Erdogan is pushing for the creation of an executive presidency as part of that process. A key driver herein seems to be the self imposed internal AK party rule which sets a three-term limit on members serving in parliament. This would mean that Erdogan and many within the current party leadership (including Deputy prime minister Ali Babacan, alongside former speaker Bulent Arinc) will have to find new positions/roles. The consensus seems to be that, after 11 years in senior cabinet roles, Babacan favours a move on from politics. He would seem an ideal candidate to serve in a high level on one of the IFIs (World Bank, IMF, et al). Erdogan, by contrast, appears in no mood to step down from his front line leadership role, and given his assumed desire to leave a lasting legacy on Turkey, the assumption has always been that his final move would be to the Pink Palace (a.k.a. the presidency). Erdogan's road appears though to be currently blocked by unease in the opposition and, indeed, elements from within his own party that he is concentrating too much power already, and a move to an executive presidency would be a step too far.
To push constitutional reform through parliament requires a three-fifths majority, or 367 deputies, or a lower threshold of 330 deputies is required to force a referendum on constitutional reform. The AK party current has 324 deputies in parliament, i.e. short of the 330-seat threshold. As a result, in recent months, Erdogan and his supporters have appeared to be looking to sidle up to elements in the opposition, first the nationalist MHP, and lately the ethnic Kurdish BDP which has 30 seats in parliament (albeit four deputies are currently in jail and in effect barred from voting).
Erdogan and his supporters currently thus appear to be looking to win backing from the BDP and its supporters to ensure a constitutional reform majority in parliament, which would then force a constitutional reform referendum. Winning support from the BDP is though in itself difficult, given that the price of such reforms will likely be further Kurdish rights reforms, possibly extending even to an amnesty's for jailed BDP and PKK members, and even a relaxation in PKK leader Abdullah Ocalan's current prison conditions. Opinion polls suggest that this would be unpopular with the wider Turkish public, and also with AK party supporters. Thus, while BDP support might ensure enough votes in parliament to push a new constitution to a referendum, winning such a vote amongst the wider public might be difficult in practice. Note that the general consensus amongst those that we meet was that ultimately Erdogan's strong personal following was still likely to be enough to carry a referendum vote, albeit it could be a close call. We heard one view that suggested that AK party officials close to Erdogan, have recently begun to back off from pushing the executive presidency idea, perhaps mindful that such a vote would be difficult to win in practice and potentially could prove very destabilising to the current political order in which the ruling AK party still dominates.
Government officials have indicated a desire to finish the constitutional reform consultation process in parliament by April, which might enable holding a referendum perhaps as early as September. Local elections are due in Turkey in 2014, parliamentary elections the year after followed by presidential elections by 2016. We also heard talk that the constitutional reform referendum might be delayed until 2014, but that Erdogan would want the issue resolved before the next scheduled parliamentary election.
Clearly, Turkey is entering an extended electoral cycle now, with three years of important ballots. We would also highlight that local/municipal elections are increasingly being seen as important in Turkey, as the AK party is eager to dominate both the local and national scene, with looming key battles in important cities such as Izmir and Istanbul. The obvious concern is that government policy will turn more populist in the run up to the votes, and more pressure will be placed on institutions, such as the CBRT to deliver on a growth oriented agenda. There is already some evidence that fiscal policy is loosening.
On the external front, Turkey also faces numerous challenges and particularly with its neighbours, Iraq, Iran and Syria. Indeed, relations with governments in all three countries appear to be at something of a recent low point - the contrast is stark, with Turkey's stated aim only 2-3 years ago of having a policy of zero problems with its neighbours.
Turkey is still struggling to determine an appropriate response to the conflict in Syria. At times, it has appeared eager to encourage/lead greater foreign intervention against the Assad regime and to bring a speedy end to the conflict. However, as one western diplomat quipped it was not entirely clear specifically what Ankara has in mind herein. Turkey itself appears wary of committing ground troops to any conflict, even as part of a broader international intervention. This reluctance probably relates to recognition of the complex situation on the ground in Syria and recognition that any such intervention could prove protracted and costly in terms of the possible loss of life. There is perhaps also recognition that Turkey's own military capacity has been significantly eroded by the recent Ergenekon and Sledgehammer cases which have seen the imprisonment of hundreds of Turkey's officer corps. The long-running conflict with the PKK also continues to stretch Turkey's military capability, and there appears to be a reluctance to do anything, e.g. with respect to an intervention in Syria, which could further undermine the efforts to counter the PKK, which remains Turkey's number priority still for Turkey's military and security services.
There seems to be recognition that the conflict in Syria will continue to drag on, and in Turkey there is much discussion as to what this means for Turkey itself. There is certainly fear of an escalation in unrest/conflict across the border - affirmed in recent weeks by a number of cross border bombings. There is also concern that Syria's own armed Kurdish groups could infiltrate the border and further complicate Turkey's own Kurdish issues - there is much talk that both the Iranian and Syrian governments might have an interest in promoting such activity to improve their geopolitical position with respect to Turkey. In terms of the economic impact of the crisis in Syria, it does seem to be disrupting trade flows to important markets in the Middle East, as Syria is an important overland route, particularly to the GCC. The direct costs though appear manageable - Turkey has learned to live/trade in a difficult region for centuries, and sometimes has prospered on the back of such disruptions. That said, we think that the crisis in Syria, and regional risks with respect to Iran and Syria, are impacting on broader consumer confidence in Turkey itself, along with uncertainty over the Kurdish rights/reform issue and constitutional reform process. We would argue that has played no small part in the slowing of domestic demand in Turkey itself.
Relations with the Maliki government in Baghdad continue to deteriorate, partially a reflection of the latter administration's strengthening association with Iran, and tensions over the position of ethnic-Turkomen in northern Iraq. And, in a remarkable turnaround from the position maintained through the "coalition" invasion of Iraq in 2003, and given domestic tensions in Turkey over the Kurdish issue, Ankara seems to be strengthening ties with the Kurdish Regional Government (KRG) in northern Iraq. This seems to reflect the political and strategic realities on the ground, and strengthening business links with the region, plus recognition that with Shia-Sunni and Kurdish tensions on the rise, the KRG perhaps offers the best hope of protection of Turkomen and Turkish interests in the region.
Similarly, and following the recent departure of US/coalition troops, the KRG seems to be increasingly looking to Turkey for protection and business/trade, including importantly for the export of oil/energy. Clearly, the latter opportunities dove-tail quite nicely with Turkey's number one longer-term economic/strategic objective of diversifying energy supply sources.
Turkey-Iran relations are similarly complicated - the two are rivals for power/influence in the region, the Shia-Sunni divide is another bone of contention, especially given that the conflict in Syria is increasingly evolving along sectarian lines, and then Ankara suspects that Tehran has been supporting various Kurdish military groups against Turkey. That said, the two are important trade partners, with Turkey significantly reliant on Iran for energy supplies, and Iran itself historically being an important market for Turkish manufactured goods. Trade ties have recently been further complicated by Western-driven sanctions against Iran, straining relations between Turkey and Iran, and also between Turkey and the West. Over the past year, the focus has been placed on a boom in gold exports, the consensus of which is that these relate to attempts by Iran to circumvent the sanctions regime. The numbers have not been insignificant, with a USD10-11bn increase in Turkish gold exports in 2012 - mostly to the UAE, and Switzerland.
The rise of the "Iranian" gold trade has itself placed greater scrutiny on Turkey's broader anti-money laundering legislation, e.g. compliance with FATF rules. As background for over a year now Turkey has been at risk of being placed on the FATF "black list" alongside North Korea and Iran, which would force FATF members to apply countermeasures on Turkey as a result of non-FATF compliant legislation/practice. In July, the FATF appeared to give Turkey a stay of execution, giving it until February 2013 to make its legislation FATF compliant or risk suspension from the FATF. It is still unclear whether this might also mean FATF black-listing - we assume it will fall short of such a move. That said, the implications for Turkish banks could still be quite significant in terms of the potential for disruption to international business/ties.
The Turkish government/parliament have recently responded by passing new legislation aimed at making Turkey FATF compliant. Doubts remain though as to whether this legislation goes far enough, with a number of other FATF members appearing critical of the legislative changes. One prominent foreign diplomat we met indicated that while he would not bet on the FATF suspending Turkey's membership, he thought that the risks of such an outcome were not insignificant. He did, however, note that there was also reluctance amongst Turkey's allies to take such a forthright step, when it was agreed that Turkey was generally deemed "de-facto compliant" with FATF rules, if not "de-Jure compliant". Indeed, it was accepted that in general Turkish banks are now working hard to comply with international best practice with respect to anti money laundering, a reflection perhaps of their desire to improve their access to international capital markets - exampled by the recent flurry in Eurobond issues by Turkish banks.
Relations with the West.
Relations with the US appear to have improved in recent months, a reflection perhaps of greater alignment in policies towards and cooperation over Syria and Iran. That said the poor state of Turkish relations with Israel, and the AK party government's continued support for Hamas remain points of contention. Similar perhaps to views within the EU, there is also some concern in the US over backtracking by the Erdogan administration on the democratic reform front.
At face value, Turkey's bid for EU accession received something of a boost in the past few weeks with news that France is unblocking one further chapter of EU law, albeit a further four remain blocked by France, and seven by Cyprus. Encouragingly though, PM Erdogan also recently spoke of not giving up on the EU project. That said, also in recent foreign visits to Central Europe, Erdogan again spoke out over what he saw as EU double standards when it comes to Turkey's EU accession bid. Nevertheless, the consensus we met was the view that the process will remain long and winding, with the outcome uncertain still, but that neither side appears yet to want to break that process. Both sides still want to remain engaged.
CBRT meeting - looks what's cooking
While in Ankara, we attended the CBRT's now regular meeting with economists, which came the day after the MPC's monthly sitting at which the bank cut its lending and borrowing rates each by 25 bps and hiked reserve ratios on FX and TRY deposits. This provides a useful backdrop for a discussion of the economy and the economic policy-setting.
The CBRT gave a general overview of how it sees the economy as context for the latest policy move. The bank noted that the past month has seen some surprising data releases, with inflation coming in ahead of expectations and the current account deficit and industrial output coming in below expectations. On the IP print, the bank argued that this went against its previous line that the economy would begin to show signs of recovery in late 2012 and into 2013. However, the bank argued that the surprisingly weak IP print was likely a one-off, as the series is volatile and historically hard to predict and driven more by exports than domestic demand. Indeed, the bank argued a range of other indicators still suggested recovery in domestic demand, including consumer confidence indicators, while it expected investment still to pick up steam over the next few months. It suggested that part of the explanation for the weak IP print could be de-stocking, and once this is out of the way, IP grow could accelerate. The bank highlighted recent strength in credit extension, as also being growth supportive, and held to its view that real GDP grow "would be at least 4%" in 2013.
The bank argued that the current account deficit adjustment lower had been more prolonged than it expected, but that it was expected to re-expand from February onwards, albeit moderately.
Inflation had surprised on the upside in January but, according to the CBRT at least, this was due to administered price hikes and tax increases, plus unprocessed food prices which are inherently volatile. It noted that core inflation measures remained relatively well behaved, and hence was not yet at the point of adjusting its inflation forecasts for the year.
Credit growth has shown signs of rapid acceleration in recent weeks, which the bank was keen to highlight explained the CBRT's decision to hike reserve ratios - note that credit growth which the CBRT has indicated is sustainable around the 15% YOY growth level, has pushed up to 20% in recent months. The bank explained the upturn in credit growth to rising consumer confidence plus perhaps the fact that low yields on TRY government debt are forcing banks again to lend to the real economy.
The bank was keen to argue that the market should take its monetary policy actions on 19 February as tightening, with the hikes in reserve requirements therein being key.
The bank explained the cuts in the bottom end of the corridor as being driven by the desire to stall hot money inflows - which it says are continuing apace - and to prevent the resultant over-appreciation of the lira, which has been approaching the 120 level on a real effective exchange rate basis at which point the bank has previously indicated it would react.
In terms of the move in the upper end of the interest rate corridor, the borrowing rate, the line was given that this is becoming less important for banks in pricing commercial loans, and the bank is keen to narrow the corridor more generally. Still it did not really give a convincing argument as to why this was needed at this point in time, and why one would not construe this as easing - going against the bank's line that it is still tightening policy. Arguably, originally the bank introduced the wide corridor to give it flexibility on the interest rate front and the high borrowing rate acted to influence on the top side the rate (worst case cost of borrowing from the CBRT) at which it banks priced commercial loans. Narrowing the corridor presumably sends a message that the crisis conditions, which had forced the widening of the corridor in early 2012, are moderating, which could put downward pressure as a result on rates of commercial lending - or at least that is my take. Suffice to say that this move was still somewhat confusing.
In terms of the success of the policy mix of keeping policy rates low so as to stall hot money inflows, the obvious question is how come 2012 saw record net portfolio inflows of close to USD40bn i.e. double the previous record annual level. Perhaps the CBRT might argue that without the CBRT response inflows would have been even higher. Still, comparatively speaking, Turkey has seen much higher inflows than other EMs, at least in 2012, i.e. the equivalent of 4-5% of GDP. The CBRT argued that this was partly driven by ratings upgrades and expectations of more to come, plus the wall of money into EM. The CBRT did not really answer the question that the bank's policy of aggressively managing the lira over the period since late 2010 might have partly been to blame, as the reduced FX volatility that has resulted has served to encourage even more inflows counteracting the CBRT's response of cutting the lending rate.
Of particular note, the CBRT argued that the lira would be much less vulnerable this time around to the potential withdrawal of hot money flows. It argued that some of these inflows are equity related (small in my view relative to bonds) and that the introduction of the Reserve Operations Mechanism (ROM) gave much more scope for banks and indeed the CBRT to manage FX liquidity - the idea is that banks have flexibility to switch between TRY, FX and gold in RRRs, depending on liquidity conditions. I have to say that I did not find this answer very convincing, given the sheer weight of net portfolio flows received in 2012, and the record stock of portfolio monies invested in Turkey, combined with the low carry now on TRY instruments. Sure, the CBRT now has the ROM, but it is untested, and the stock of portfolio holdings is so much larger than for the period 2011 to mid-2012 when it really struggled to fight depreciation pressures. Gross reserve levels are also very modest still by international standards and relative to external financing needs. I guess the CBRT would hope that its actions over the past couple of years, i.e. showing the market that it cares and even targets the exchange rate, and are willing to be proactive and take the market on, will counter the risks of a wholesale exit.
While the CBRT is obviously institutionally strong - amongst the best globally - and no doubt has some very clever individuals, I fear that they are still perhaps trying to do too much.
I, for one, could not quite understand why they made any changes in policy at the last MPC meetings, given the data flow was decidedly mixed. Surely a traditional central bank approach would have been to do nothing, let previous actions further take effect and wait for better data flow. Indeed, I did not see anything pressing and compelling on the data front that drove the latest policy responses.
This does then leave one with the impression that this is a central bank that loves to tweak its policy tools (and it has a bigger tool kit than most) and likes to play around with them to see what will work here and there. Indeed, it is incredible that the bank does feel that its various tools have such very specific impact, i.e. lowering the lending rate to cap hot money inflows, and hiking RRRs to slow credit growth, and to target such a specific rate in this latter respect. The obvious concern is that it still has too many objectives and too many policy tools. The most obvious metaphor is of a chef (maybe even Michelin star) trying to bake in an oven and having to figure out the right temperature, how long to leave the oven on and on what shelf to place the baking tins. Now this might be fine when baking a single cake, but in this instance it seems to be trying to bake a souffl (financial stability, hot money and its impact on the exchange rate) and perhaps a date and walnut cake (inflation). Now either the cakes might not rise, or might burn, but it will take a chef of great skill and expertise to pull this one off. Keeping to the cooking theme, surely this central bank has thrown out all the cooking books in its move to a very unorthodox, "cooking by hand" approach to monetary policy. It needs to peer through the oven door constantly, and perhaps make subtle adjustments all the time.
Titbits from the trip
Beyond the CBRT meeting, discussion was very much focused on the state of the economic recovery, with views very much divided therein. There was though a sense of surprise even from the Turkey growth bulls (including yours truly, and the CBRT if the meeting with economists was anything to go by) at the lack of clear evidence of a pick up in the pace of growth. Drags on growth remain:
* CBRT policy, if the central bank is to be believed; the weak European and global growth outlook;
* heightened domestic political uncertainty over the constitutional reform process plus concern over regional risks/conflicts in Iraq, Syria and Iran.
Interestingly though, the latest CBRT expectations survey indicated that participants still predict 4% or so real GDP growth for 2013, so bang on the CBRT's forecast. That said, the survey was conducted before the latest IP print.
In the context of the debate over growth, recent government interventions against the central bank policy were interesting, in particular comments by the minister of economy, Zafer Caglayan, that policy rates need to go lower if the economy is to meet government targets of making Turkey a top-10 global economy over the next decade or so. This has created concern over the independence of the CBRT - not that the bank appeared overly concerned by this. There are though concerns that in the run-up to a referendum vote on a new constitution and, as the country heads into election season, that fiscal policy will be loosened. Already herein, in the first few budget data prints for the year, there is evidence of a marked pick-up in non interest spending, albeit the headline deficit is contained by strong revenue growth, helped by hikes in consumption taxes, and one off revenues from privatisation. Still this does need watching and especially in the context of a still vulnerable current account position.
On the balance of payments front, there was recognition that some rebalancing has occurred, but that the improvement in 2012 flattered to deceive somewhat by one off items such as gold sales, presumably by agents of Iran. Thus, while the headline current account deficit moderated from USD77bn in 2011 to USD46-48bn (depending on adjustment higher in tourism revenues) in 2012, the deficit is likely to re-expand to perhaps in excess of USD60bn this year.
The key vulnerability though remains the quality of financing of the current account deficit. Also, the huge weight of net portfolio flows - ~ USD40bn in 2012 - still leaves Turkey very vulnerable to a reversal of current liquid global market conditions. Further, net FDI flows disappointed in 2012 at only around USD8bn, and herein the government needs perhaps to provide more clarity on the future of big ticket sales in the energy and transport sectors.
The trip has made me view my broader recommendation on Turkey, in particular, the outlook for the exchange rate. The consensus seems to be that aggressive CBRT management will hold the lira broadly unchanged around current levels. Increasingly, I struggle with this view:
First, the CBRT has openly stated that it wants the currency weaker, or at least wants to prevent further appreciation and is prepared to act; be careful what you wish for.
Second, both the flow and stock levels of portfolio investment are at record highs, and in my mind, what goes in can easily go out, and especially if we see a reversal of global risk appetite, perhaps with an out of consensus growth/recovery in the US and China which could force USTs to further adjust higher.
Third, market rates are low (benchmark TRY bond now at 5.75% with inflation at 7.1%) and offer very little carry protection for portfolio investors.
Fourth, we expect the current account deficit will re-accelerate into 2013 if the CBRT's current upbeat growth assumptions come to pass. This will mean an increased external financing requirement to fill.
Fifth, we are giving up hope of near-term ratings upgrades by either S&P or Moody's. We continue to believe that Turkey is deserving of full investment grade (strength of public finances plus proven willingness to pay are key herein), and that the ratings agencies are behind the curve, but both Moody's and S&P appear to put too high a weight on external financing risks. Hence, we think they will delay any upgrade, especially given our expecting that the current account deficit will re-expand in 2013. We would argue that if the current account is not financeable, the lira will adjust weaker but, that, given the low level of external leverage still throughout the economy, this should not impinge on the sovereign's ability to pay. That said, with the current account deficit expected to re-widen this year, and given the weight of portfolio investment financing, we simply think that both the latter two agencies have missed the opportunity to right the injustice (on Turkey) of the past, as did Fitch. Thus, given that they have not moved yet, they at unlikely to, in our view, for some time yet.
We thus think that the risks of a sizeable currency adjustment this year are not insignificant. And, indeed, our base case is that the lira will be back at around the TRY1.90 level against the USD by year-end. From the CBRT's perspective, arguably this would be good news, as it would release them from having to manage a wall of inflows, it would create a more competitive currency, and further help with the current account adjustment. Increased FX volatility would also help counter further hot money inflows, making the management of monetary policy that much easier going forward. We do think that the Turkish economy will be able to live with a weaker currency, without this creating broader systemic risks. This will just be a healthy FX correction, albeit the CBRT might be forced to move to tighten policy by hiking policy rates in a more orthodox fashion. It could thus mark the end of the bank's unorthodox policy dalliance.
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