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Turkey: does the low price justify the risk?

The country is one of the cheapest emerging market economies to invest in, but it is facing political instability, a weak currency and high external debt
June 16, 2017 & Leonora Walters

Measured by key economic terms, by the end of last year Turkey had plunged to its lowest point since the financial crisis. Concerns about government stability, terrorist-related attacks and a rising US dollar following the election of Donald Trump sent the lira tumbling. Foreign investors have also shunned the market, which was once looked upon favourably due to its rapidly growing domestic demand for goods and services, as well as its geographical positioning straddling Europe and Asia.

But sentiment could be on the turn. Last July’s failed military coup – which resulted in the deaths of almost 250 people – against state institutions has been one of the biggest sources of mistrust among foreign investors in Turkey. Since then, a state of emergency has been in place within the country. Almost 12 months on more than 110,000 people have been arrested, but just 50,000 on specific charges, according to Turkey’s Ministry of Interior. No one has yet been convicted, but the trial of around 200 military officials accused of plotting and orchestrating the failed coup is now under way. What’s more, around 100,000 civil servants, military and police have also been sacked for allegedly having links with the exiled US cleric accused of masterminding the coup.

In April just over half of the Turkish electorate voted in favour of constitutional reform that would give divisive president Recep Tayyip Erdogan greater powers. The changes – due to be introduced by 2019 – will turn the country into a presidential republic like the US or France, and could enable Erdogan to remain in power until 2029. Markets have reacted positively to the news. The Istanbul Borsa 100 has gained 9 per cent since April’s result, while the lira has regained some of the ground it lost during the past 18 months.

Much of this hope has been pinned to economic reform by the ruling Islamist AK Party, where Erdogan has retaken his place as leader. In January, ratings agency Fitch downgraded Turkey’s sovereign debt to junk status, citing the erosion of checks and balances and institutional independence. However, the approval of the executive presidency could help improve economic growth by giving the government room to accelerate structural reform and improve growth, the ratings agency has argued. These much-needed reforms include improving an underskilled labour market, an unproductive agricultural sector and a weak record in attracting foreign direct investment.

However, political stability is still some way off. The government extended the state of emergency for three months, just two days before it was due to expire in April. Meanwhile, some EU lawmakers called for a halt to accession talks over Turkey’s heavily delayed application for EU membership, arguing that Erdogan’s growing authoritarianism does not meet democratic standards. European Commission president Jean-Claude Juncker also said the reinstatement of the death penalty – which Erdogan said he would approve if parliament submits a proposal or a referendum backs it – would put an end to accession talks.

Ashmore (ASHM) head of research Jan Dehn remains sceptical about the government’s will to make real economic reform. “Erdogan wants an Asia-style growth model, but Turkey does not have the savings and the quality of investment required to grow like Asia did,” he says. “In a bid to force the pace, he exerts pressure on the central bank to ease monetary policies too much. This is creating an excessive credit boom.”

 

Reigniting growth

With a lack of natural resources and a rapidly growing population, Turkey has historically been a net importer of goods and services. However, its current account deficit has widened even further in recent years. Much of its gross domestic product since the financial crisis has come via a surge in domestic consumption, rather than productivity. Turkey’s productivity growth has always been volatile, but during the past seven years it has been meagre by emerging markets standards. In 2016 industrial production grew just 1.6 per cent (see chart), although it has started to pick up again.

That has made Turkey increasingly reliant on foreign direct investment for economic growth. As a result, the recent political and security tensions have hit the country’s development particularly hard. Foreign inflows almost halved to $6.9bn last year, the lowest level in six years (see chart below), according to the Turkish central bank. However, foreign investment in the country’s banking sector surged during March to $912m, compared with just $52m during the whole of the first quarter of 2016.

In fact the banking sector has been a source of encouragement for the country’s wider economic health. Net profit at Turkey’s banks rose 65 per cent during the first quarter, according to Turkey’s banking regulator, BDDK, leading to profit upgrades for the full year. The government-backed Credit Guarantee Fund has encouraged lenders to increase lira-denominated loans to businesses. It guarantees non-performing loans made by banks to providers of goods and services in local currency, and in March was extended to 250bn lira (£55.8bn).

An easing of tension between Turkey and neighbouring Russia may be another reason for optimism. Most recently the Kremlin said it would lift a ban on Turkish companies operating in Russia and ended an embargo on a range of Turkish imports. President Putin imposed sanctions on its neighbour after the Turkish military shot down a Russian jet over the border with Syria 18 months ago. The tourism industry was hurt particularly badly by a ban on Russian package holidays to Turkey, although this was one of the first sanctions to be lifted by Moscow. Russian tourist numbers declined to less than 1m last year, compared with 3.6m in 2015. However, security concerns relating to both terror attacks and protests against Erdogan’s leadership have also brought down overall foreign visitor numbers. But this has been picking up again during recent months, according to data from the Turkish Tourism Ministry (see chart below left).

Nevertheless, the International Monetary Fund recently cut its forecast growth rate for the full year to 2.5 per cent, down from the 2.9 per cent initially expected. It cited the lira’s depreciation, the rising debt burden and geopolitical pressures as factors in its downgrade. However, the government has once again stated that it has a 4 per cent growth target for this year.

Turkey's debt mound

The Turkish lira was one of the worst-hit currencies following the election of Donald Trump in November, losing 7 per cent of its value in 10 days. It wasn’t so much the new US president’s protectionist policies that were the concern, but the threat of interest rate rises by the Federal Reserve. That’s because, during the past decade, the level of dollar-denominated debt owed by Turkish corporates has surged. In fact, Turkish companies have run up dollar-denominated debt at a pace second only to that of China, during the 10 years to 2015.

Turkish companies must therefore generate enough foreign currency to meet their debt repayments. One way companies could do this is by exporting goods, although exports have collapsed during the past two years. Making enough lira domestically could also prove difficult, given the slowdown in economic output during the past 12 months. The downturn in tourism, which has traditionally been a source of dollar-denominated income, has also not helped the corporate sector. Admittedly, the majority of external debt owed by the private sector is long-term debt. Of the $219bn in external debt owed at the end of March, 7 per cent or $15.1bn was due for repayment during the next 12 months, according to the Turkish central bank.

The weakness of the lira has also resulted in a scarcity of domestic funds, as individuals and companies hold a greater proportion of their deposits at the bank in dollars or euros. This puts pressure on the banking sector’s ability to write lira-denominated loans. What’s more, inflation has run into double digits as goods and services costs have risen. While president Erdogan has repeatedly declared his opposition to higher interest rates – calling them “a tool for exploitation” – the central bank has steadily increased its benchmark rate this year. It raised the late liquidity window – used for about 90 per cent of recent funding to commercial lenders – by 50 basis points to 12.25 per cent in April.

Investor sentiment towards Turkey is improving. The Borsa Istanbul 100 is trading at around 9.3 times next-12-month forecast earnings, up from 7.7 times at the end of December. The index has increased markedly since January. On a cyclically-adjusted price-to-earnings basis, however, Turkey is still the most lowly-rated emerging market, second to Russia. However, Elena Tedesco, emerging market equities specialist at Hermes Investment Management, says that despite its outperformance versus the MSCI Emerging Markets index so far this year, Turkey remains a cheap market. “The central bank has delivered to the markets what they wanted: overnight lending rates have been hiked from 8.1 per cent in October 2016 to the current level of 12.4 per cent, offering positive real rates despite mounting inflation,” she says. The weighted average cost of central bank funding has followed the same trajectory and such tight monetary policy has supported the lira, which is almost flat in the year to date versus the dollar, she adds.

Cape ratio
Emerging markets 14.9
Brazil10.7
China14.4
India20.3
Indonesia18.8
Mexico22.2
Poland11.4
Russia5.3
South Africa17.6
Turkey10.1
Source: Star Capital *at 31 March 2017

However, significant economic reforms have yet to be made by the government and opposition to Erdogan remains high. What’s more, external debt is still climbing – exactly when, or if, this pushes a significant proportion of the private sector into defaults remains to be seen. Like most emerging markets, investing in Turkey is best accessed by retail investors through actively managed funds. If you want to gain a small amount of exposure to this high-risk economy, we’ve included some of the most appropriate funds in the box above.