Turkey
What’s Hot and What’s Not in Ankara
June 04, 2008

By Tevfik Aksoy | Istanbul

We visited Ankara to meet with key officials at the Turkish Treasury, the Central Bank of Turkey as well as the IMF. In general, the meetings confirmed the challenges facing Turkey’s combat with inflation, at least in the short term, a likely tightening in monetary policy and a rather cautious, but somewhat comfortable, approach to the fiscal stance amid lingering uncertainty on the political front.

Medium-Term Fiscal Program Is Likely to Help Lower Debt/GDP, but Reservations Remain

We discussed the medium-term fiscal outlook and the government’s recent announcement of the fiscal framework with the Turkish Treasury officials. Essentially, the officials underscored the government’s intention to lower debt/GDP, which would be possible under the targeted primary surplus (PS) and the underlying macro assumptions. We were told that a detailed macro framework pinpointing each key variable, including GDP growth and inflation forecasts, would be disclosed in early June.  According to the Turkish Treasury, the revised PS target of 3.5% of GDP for 2008 actually did not signal a fiscal loosening in comparison to 2007, since PS was exactly the same. That said, there would be increased spending in infrastructure, especially in the Southern Anatolian Project (GAP), that would receive the majority benefit of the downward revision of the PS from the initial 4.2% to 3.50% of GDP.  Not only the Treasury officials, but also the IMF seemed to be comfortable with the changes in fiscal targets, as the spending on infrastructure is expected to bring productivity gains and help cut unemployment. The overall investments in the GAP project is expected to reach TRY 25 billion in the next five years.

Aside from the investments in the GAP, the government lowered the social security premiums to the employer and raised the share of revenues of the local administrations (municipalities) from tax revenues. While the former is expected to lower the share of the unregistered economy in the medium term, there was no convincing argument for the latter, especially given the upcoming local elections in March 2009. The IMF did not seem to be very comfortable with the measures related to the local administrations, as there seems to be a degree of ambiguity, but the overall view was that the medium-term fiscal plan was strong enough to lower debt/GDP. Nevertheless, the Fund officials were disappointed regarding the re-introduction of the amnesty for the social security premium arrears. The officials at the Central Bank of Turkey (CBT) seemed broadly comfortable with the fiscal framework and, as the CBT governor reminded us, he had his signature on the latest Letter of Intent (LoI) submitted to the IMF, which should be seen as his approval for the move. However, the CBT was not comfortable regarding the attempt to raise the revenues of the local administrations. It seems like the issue needs to be scrutinized in the coming months, especially as the local elections approach. In our view, the market may be affected by the lack of a strong IMF program as concerns surrounding the fiscal position escalate. On the state of the current relations with the IMF, the Fund officials indicated that the Post Program Monitoring had not been enacted yet (this requires Board approval), and the lack of clarity towards the future mode of relations with the government remained. Our sense is that the government might opt for a precautionary standby arrangement in the coming months, but it seems like the cabinet members do not fully sponsor such a decision at this point.

No Food or Energy Subsidies on Agenda

A common (and increasing) fiscal problem in various emerging countries is the government subsidies offered on food and/or energy costs. Our meetings in Ankara confirmed that there is no such pressure on the government at this point, and the Treasury officials assured us that it is not even a topic of discussion. Currently, retail gasoline prices are determined automatically in conjunction with the changes in global oil prices and the movement in the currency, and a similar system is expected to be enacted in the electricity market starting July this year. The government’s recent decision to raise natural gas prices by 7.4% effective June 1 was also an indication of rational pricing, in our view.

A Fiscal Rule?

The lack of a strong IMF-sponsored program calls for some anchoring of the fiscal position. A widely discussed option between the government and the Fund staff had been the introduction of a fiscal rule, which seems to be on the agenda these days.  In our view, a rule-based fiscal approach would be highly beneficial to keep fiscal concerns at bay, with or without close ties with the IMF.

On Treasury Debt Issuance

The Turkish Treasury’s domestic debt redemption schedule is quite heavy for the June-August period and is likely to reach TRY 50 billion (mostly in July and August at TRY 25 billion and TRY 18 billion, respectively). Later in the year, the burden will decline but not significantly and, hence, the pressure on yields could linger. However, the Treasury officials expect significant inflows from the primary surplus, especially in May (which has materialized) and in August, in line with seasonal factors. Under conservative assumptions on external financing and no proceeds from privatization (or from the Savings Deposit Insurance Fund – SDIF), the authorities believe that a 70% rollover ratio could still be maintained. We were specifically told not to expect the rollover rate to rise to 80-90% levels. The underlying assumption here is that the Turkish Treasury will not hesitate to de-accumulate part of the Public Sector Deposits that had reached approximately TRY 25 billion in May. Meanwhile, the Treasury expects the Turkish banking sector to extend limited loans to the private sector in the coming months, which might create additional demand for government bonds. On part of issuance in global capital markets, the Treasury still has a US$5-5.5 billion target, of which US$2 billion had been realized. We did not get the sense that the Turkish Treasury is determined to borrow in case spreads widen, and the level of interest in Turkish debt is less than ideal.

Liquidity to Remain Tight in the Near Term

One of the topics we discussed in detail with various officials was the ongoing liquidity tightness in the market. It had been claimed that the reasons behind this were purely redemption-based in nature and, during June, the conditions might not change much. In addition, the taxation schedule did not help with hefty tax payments, resulting in a shortage of cash. There was a broad-based consensus that the high redemptions set for the July-August period might ease the liquidity with the de-accumulation of the Treasury’s fiscal reserve. Central bank officials reiterated that while the official borrowing rate remains as the main policy rate, it might shift to the lending rate, depending on liquidity conditions in the market. During our discussions, we were specifically told that the CBT would not change the maturity and the method of its funding policy in the near term.

Policy Tightening Has Little, if Anything, to Do with Short-Term Inflation Outlook

The CBT officials acknowledge that the policy tightening would have a marginal impact on headline inflation in the short term, given the already suppressed demand conditions. However, the hawkish stance is likely to remain in place in order to fortify the inflation-targeting framework and enhance the credibility of the CBT. That said, our impression is that the CBT will consider every new development and data before making a final judgment on rates at the MPC day without a prior bias. That is, there is no clear signal on hand that the next rate move might be another 50bp tightening such as the last one (i.e., it could be 25bp). We maintain our view that a 50bp (to 16.25%) further hike is likely, but beyond that it would depend on a set of variables ranging from the currency, global market sentiment, oil prices and, most importantly, inflation expectations. Regarding the latter, the bank officials stressed that the direction of the changes in expectations is what matters most, rather than the absolute level. On that note, the recent data point to a very slight improvement with a rather moderate deterioration in both 12- and 24-month forward-looking inflation expectations. The officials acknowledged the fact that the overall expectations picture deteriorated following the release of the latest inflation report when the bank introduced a sizeable revision to its CPI forecast for 2008 and 2009. Compared to the inflation and outlook picture of the inflation report, oil prices are higher, food prices are rather stable and the currency is stronger, leading to a mixed view.

Changing the Inflation Target?

The issue of revising the official inflation target is no longer off the agenda in Ankara.  Almost all of our contacts mentioned the likely possibility, especially following the forecast revision of the CBT. At this juncture, it seems possible that the new CPI target(s) for 2008 and beyond might be jointly determined by the CBT and the government at the time of budgetary preparations (if not earlier). Hence, we are looking for the September-October period for the announcement of the new targets.

Turkey
Current Account to Widen: TRYing Too Much?
June 04, 2008

By Tevfik Aksoy | Istanbul

The sharp rise in oil prices had been pressuring Turkey’s current account in recent years; this might become more pronounced in the coming months, especially with oil prices at record levels. Our official view is that oil prices might remain high in the near future, and hence currencies such as TRY might come under pressure at some point. The fact that the lira had been appreciating in broad terms – thanks to high nominal interest rates as well as the technically supportive positioning of the local retail investor in FX deposits – and the remarkably successful FDI story between 2005-07 has left investors less wary of the wide current account deficit. In fact, Turkey’s widening current account deficit had been a topic of interest for years, but the attention was successfully diverted by the developments on the capital account side. Ample financing offered to the banking and the non-financial sectors from global markets left little, if any, need for Turkey to seek portfolio investment to finance the gap. To provide some perspective to the picture, it might be worth mentioning that the average annual portfolio flows (both into equity and debt securities) amounted to around US$4 billion in the past five years, which appears rather small in comparison to the headline current account deficit of US$40 billion. Over the past 12 months, the direction of portfolio flows had been negative at US$5 billion.

On the other hand, the so-called ‘other investments’ – capturing both banking and the non-financial sector borrowing from abroad – reached significantly high levels. As of March 2008, the 12-month trailing figure stood at around US$31 billion. At this juncture, we believe that there is no solid reason for this financing item to decline noticeably, especially considering that even during the initial phase of the US subprime jitters, local companies faced no difficulty in rolling debt but a marginal rise in borrowing spreads.

Current Account Under Base Case and Various Oil Prices

Clearly, making the right assumption for oil prices had been a challenge over the past year, with prices reaching new highs by the week. Using the Brent oil futures data for May 15, which we currently take as our base case scenario for the next 18 months, our average oil price assumption is US$115.7/bbl for 2008 and US$123.2/bbl for 2009. In order to reflect Turkey’s overall cost advantage in import prices in retrospect, we deduct some US$3/bbl to arrive at approximately US$113/bbl for 2008 and US$120/bbl for 2009. The main reason behind the lower cost of oil for Turkey had been the proximity to the importing countries, as well as the previous engagements for delivery contracts.

Given the fact that the average price of oil so far in 2008 remained at US$106/bbl, even if prices stay in the US$130/bbl neighborhood, the full-year average will rise to US$120/bbl. Compared to our base case assumption, this would incur an additional burden of US$1.8 billion on the current account, which we deem as broadly negligible for the purposes of a macro assessment.

Lower Growth Should Improve Non-Energy Current Account

We have recently revised down our GDP growth forecast to 3.5% for 2008 and 4.5% for 2009, from 4% and 4.8%, respectively. In line with this revision, we expect Turkey’s non-energy imports to rise relatively slowly, especially in comparison to the remarkable growth in the previous years. Under our base case assumption of a US$116/bbl oil price, we forecast Turkey’s current account deficit at US$52 billion, or 7.1% of GDP. This would be a noticeably high deterioration in the headline deficit, especially in comparison to 2007, when it stood at US$37.4 billion, or 5.7% of GDP. Essentially, the change had resulted predominantly from the rise in global oil prices. Given the ongoing uncertainties surrounding oil prices, as well as the high sensitivity of Turkey’s current account deficit to the changes in price assumptions, we tested a range of prices and showed the overall impact on the current account.

In case oil prices remain at current levels, we believe that our base case scenario is likely to hold, which might be perceived as somewhat optimistic, given the rapid rises in oil prices in recent months. Compared to the optimistic case of a US$100/bbl average price, wherein Turkey’s current account deficit would be limited to around US$45 billion (or 6.2% of GDP) in 2008, a price of US$200/bbl could result in a very serious deficit of US$88.6 billion, or 12% of GDP.

We should note that the analysis above has limitations since it ignores the dynamic response of various macro variables to the changes in oil prices, especially if extreme values of US$200/bbl are attained on a permanent basis (at least 18 months). Such a high price is likely to result in a sharper slowdown in growth, quite possibly leading to a surplus on the part of the non-energy current account balance. Moreover, the rising price would lead to a decline in the quantity of oil consumed, accelerating inflation and depreciation in the currency, which would have second-round effects on foreign trade. That is, such an extreme case is likely to result in a self-correcting cycle in the economy, given sufficient time.

The ‘Basic Balance’ Needs a Revamp

Following the successful privatization and private sector FDI realizations of 2004-07, a noticeable slowdown materialized starting in mid-2007. The basic balance (current account balance plus FDI) on a 12-month basis declined to one of the lowest levels in years, with both a widening of the current account deficit and the lack of fresh FDI flows. We expect the indicator to improve somewhat with the addition of the recent payment of the Petkim sale, but this will probably be quite limited, as the monthly rise in the current account deficit has been remarkably high. The recent public offering of Turk Telekom shares will be a boost to the capital account as well; however, we do not consider that as part of FDI. 

Financing via FDI Likely to Remain Limited

We maintain our view that the government will try its best to finalize the sale of four electricity distribution networks, toll highways and bridges, the state lottery, the ports and sugar factories. With the addition of the already closed deals, we expect US$16.5 billion for FDI, but we believe that the risks to attaining this figure are heavily tilted to the downside. Not only might the global market conditions hinder widespread participation in privatization deals, but also the proceeds of the sales might not be received in 2008, especially if administrative or judicial delays materialize. We pencil in a similar FDI figure for 2009, which is mostly contingent on the improvement of the political picture on the domestic side, as well as a recovery in global risk appetite, since the sale of some state banks is assumed in these forecasts.

The ‘Others’

With portfolio flows remaining limited (and, in fact, turning into an outflow following the US subprime jitters), as well as the FDI flows being stagnant, the main financing item had been ‘other investments’. These comprised both the banking and the non-financial sector borrowing, which reached US$31 billion (on a 12-month rolling basis) as of 1Q08. Our understanding is that the Turkish corporate sector faced little, if any, distress from the tightening credit conditions so far. With a marginal rise in borrowing spreads, the funding seems to have remained ample, at least in 1H08. While there is no guarantee that this might be the case in 2H, we believe that the other investments will be the main financing item of the current account.

Don’t TRY Too Hard: The Level of the Currency Is Not Reflecting the Potential Risks

Notwithstanding deteriorating pressures on the current account, mostly as a result of rising energy costs, the currency had been appreciating recently and testing below the 1.21 level.

In our view, the current level of TRY within the 1.20-1.25 range is not pricing in the upcoming deterioration in the current account (which is likely to occupy the agenda) or the outstanding risks on the political front (the AKP closure case, the possibility of early elections and the second-round effects on fiscal policy). We regard the recent appreciation move as part of a short-term trading strategy on the part of fast money accounts, the lingering tight liquidity conditions in the Turkish money market (which is expected to last for most of June) and the marginal improvement in risk appetite in global markets. We do not see any of these reasons as sufficient enough to take sizeable TRY risk at this juncture, especially taking into account our expectation that political uncertainty might linger for at least another 4-6 months.

Tight Liquidity and Lack of Non-Resident Interest Keep Yields High

One noteworthy observation is that both the equity and the bond markets had been weak, despite the noticeable appreciation of the currency. In fact, the ‘de-coupling’ of these markets had been quite apparent for the past few months. Of course, the lack of interest in local markets by non-residents played a significant role in this, especially in the bond market, where the overall exposure of foreign investors eased to TRY 33.4 billion, or 16.7% of the market debt as of May 2008. At the peak of interest in Turkish debt securities, non-residents held TRY 44.6 billion, or 24% of the market debt (as of July 2007).

While the current benchmark bond yield looks attractive, especially in comparison to the CBT policy rate (although the money market rate had been higher than this recently), the lingering adverse liquidity conditions and the upcoming heavy redemption schedule during the July-August period might suppress appetite. In fact, the anticipated tightening in the CBT policy rate at the next MPC meeting is another factor limiting exposure to bonds, in our view. However, the technical picture looks attractive, with low positioning, and there is a high possibility that the Turkish Treasury might resort to the de-accumulation part of the public sector deposits held at the CBT during the summer months in order to lessen the pressure from hefty redemptions. During our discussions with Treasury officials, it was confirmed once again that the 70% debt rollover ratio would be maintained on average; hence, there might be only limited room for a further widening in spreads.