Special Report - Turkey - Sept 2015

Special Report | September 2015 1

Special Report

Turkey – The Post-Election Aftermath & Challenges Ahead

AMIR KHAN ECONOMIC RESEARCH | LONDON T: +44-(0)207-577-2180 E: [email protected]

The Bank of Tokyo-Mitsubishi UFJ, Ltd. A member of MUFG, a global financial group

SEPTEMBER 2015

ontrary to expectations, the parliamentary elections in Turkey held on 7 June failed to deliver a decisive outcome, with the ruling AKP party wining the most seats but not enough to govern on its own. While it was hoped – somewhat optimistically in our mind

– that a coalition agreement could be struck between the major parties, their failure to settle their differences has paved the way for a fresh round of elections that will take place on 1 November. If this wasn’t enough, other headwinds facing Turkey have also risen recently, with for example the country’s currency in the line of fire, as investors reassess the country’s prospects going forward in light of the inconclusive election result and the imminent prospect of the Fed raising benchmark US interest rates. Against this backdrop, the purpose of this note is to explore in some detail the challenges that are likely to confront Turkey going forward, as well as to gauge the prospect of much-needed structural reforms taking place in the country. Political uncertainty takes centre-stage… The markets have taken a dim view of the outcome to the Turkish election held on 7 June, with the local currency and other markets seeing a sharp sell-off (see Chart 1). That said, there is a perception in some quarters that this negativity is not necessarily justified. Indeed, according to this viewpoint, despite the bitterness that characterised the highly polorised election campaign, the polls themselves were conducted peacefully and the election result was not seriously contested, suggesting a gradual maturing of the political tradition/institutions in Turkey.

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1/2015 3/2015 5/2015 7/2015 9/2015

TRY per USDTurkey benchmark equity index

(Index, Jan 2015 = 100)

Parliamentary elections

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87.5

(month/year)(Source) Macrobond

Chart 1: The inconclusive election result has spooked the markets

C


Additionally, some critics of the previous AKP-led governments have also welcomed the election result on the grounds that it will prevent the current president, Mr. Erdogan – who formerly occupied the role of prime minister and remains a key figure in the AKP party – from amassing too much power and turning the ceremonial role of the president into an executive one. While there is clearly some truth to this assertion, it is worth pointing out that such an outcome has not been without its costs given the elevated political uncertainty/policy paralysis that has beset the country since the announcement of election result. Separately, the fact that a coalition agreement was not reached between any of the major parties – particularly the two largest, AKP and CHP, who together represent a fairly broad spectrum of Turkish society – is also, in our mind, somewhat troubling and gives rise to a number of key considerations: First, it dashes market hopes, for now at least, of a move towards more consensus based

policymaking in Turkey and serves to highlight the deep divisions which exist between the major parties – and indeed society in general – in Turkey.

Second, the failure to reach a coalition agreement is likely to mean that the heightened political uncertainty seen in the run-up to the June election could extend into the rest of this year and even into next, with negative implications for the economy.

Third, with the ongoing political uncertainty in Turkey (the lack of a government and the

offensive against PKK rebels/ISIS positions) this is likely to undermine the country’s standing in the eyes of the markets. As such, we are of the view that this may provide a pretext for market participant to continue to sell Turkish assets beyond what would be justified on fundamental grounds alone1.

That said, it is worth adding here that for the AKP – and Mr. Erdogan who despite stepping up to assume the role of the presidency earlier this year perhaps remains the most important figure in the party – the decision to instigate early elections is better than the alternative of presiding over a minority government or – for that matter – a fragile coalition government with one of the opposition parties. Indeed, there is some truth to this viewpoint, with past experience of previous coalition governments in Turkey suggesting that they tend to be short-lived and are characterised a period of heightened political volatility. Indeed, it is useful to recall that the last minority government in Turkey was formed in January 1999 and fell apart just four months later. The last coalition government was formed soon after the minority government failed, in May 1999, and collapsed in 2002. Notwithstanding this, if recent opinion polls are any guide, a repeat election is unlikely to deliver a hoped-for majority for the AKP, which would require something in the region of 45% of the popular vote versus a figure marginally above 40% that the party is currently registering in the opinion polls (see Table 1). The implication of all this is that even in the event of a follow-up election, there is no certainty that a majority government could emerge, with the result that a second attempt at piecing together a coalition government may have to follow which, if the previous attempts at forming a coalition government is anything to go by, could prove highly protracted or uncertain in nature.

1 The Turkish lira has fallen around 30% in the YTD against the US$, with the currency recently breaching 3 liras per US$, which according to the Economist’s “Big Mac Index” makes it almost 20% undervalued versus the US currency.


…Exposing the challenges facing the economy One thing that is clear is that whoever takes the helm of government will face considerable challenges managing an economy that faces acute near to long-term challenges and vulnerabilities. Although Q2 GDP growth figures surprised on the upside (3.8% y/y) and exceeded the previous quarter’s reading by a comfortable margin (2.3%), this was largely driven by the uptick in domestic sources of demand (see Chart 2), which we view as unsustainable in light of the worsening in consumer confidence, a development which, in turn, appears to be closely correlated to the falling value of the local currency unit (see Chart 3). Inventories and net exports, meanwhile, were a significant drag on growth. Going forward, we expect household and investment spending to slow in the remainder of this year on the back of political uncertainty, deteriorating private sector confidence and a weak currency. Indeed, as a consequence of the deterioration in Turkey’s operating environment and policy mix, we judge that growth for the full-year, at around 2.5%, will continue to undershoot the country’s long-term growth potential of around 4%.

(%)

AKP CHP MHP HDP Other

40.9 25.0 16.3 13.1 4.8

Sonar 38.2 28.0 18.2 13.7 1.9Metropoll 41.4 27.3 15.3 13.0 3.0

ORC 43.7 27.5 14.3 11.2 3.3Gezici 38.9 27.8 16.3 13.5 3.5

Argetus 42.6 25.5 15.4 12.5 4.0AKAM 39.7 28.5 14.8 12.6 4.4

Average 40.8 27.4 15.7 12.8 3.4

(Source) Opinion polls

June-7 result

Latest opinion polls

Table 1: Opinion polls for forthcoming elections

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Domestic consumptionGovt. SpendingInvestmentNet ExportsInventoriesGDP

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(Source) Turkstat, Macrobond

Chart 2: Turkish latest growth performance was better than expected thanks to strong domestic demand...

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(Source) Turkstat, Macrobond

Chart 3:...But waning confidence led by the fall in the local currency unit suggests

that this is not likley to be sustained

(year)

(TRY/USD)


Additionally, despite the negative output gap and a drop in energy prices, Turkey’s inflation is still high and its current account deficit is still large, compared to other key emerging markets (see Chart 4).

The country has been “muddling through” with its poor macro mix on the back of its long-term growth prospects, a QE-driven supportive external funding environment, and the relative strength of some of its institutions. But, in our mind, if temporary political uncertainty were to turn into permanent political risk premium, it would be difficult for Turkey to do the same. The Short-term challenge: rebalancing, deleveraging Corporate sector

Turkey’s key vulnerability – its large external financing requirement – is well known. The country has a persistent current account deficit that is financed by portfolio flows and cross-border borrowing as opposed to FDI flows that are deemed to be more stable or less “footloose” in nature. Fortunately, low oil prices and abundant global liquidity have somewhat eased the pressure associated with this fundamental weakness. However, we see no lasting reduction in external vulnerability. The current account deficit narrowed on the back of lower growth and is set to narrow further in 2015 on the back of lower oil prices, though at over 5% of GDP it remains relatively high. Meanwhile, the country’s total external financing requirement remains sizeable (see Table 2) thanks, in large part, to the stubbornly high debt amortization schedule on the part of the private sector.

(US$bn)

Dec-12 Dec-13 Dec-14 Mar-15Current account deficit 48.5 65.0 46.0 45.0Debt Amortisation 144.2 167.7 166.8 163.9

Public sector 8.4 7.5 6.3 4.5Private sector 135.8 160.2 160.5 159.4

Non-financial 60.5 60.7 53.0 50.7Financial institutions 75.3 99.5 107.5 108.7

Total External Financing requirment 192.7 232.7 212.8 208.9

Current Account deficit (as % of GDP) 6.2 8 5.9 5.9Debt amortisation (as % of GDP) 18.3 20.5 21.2 21.4Total external financing requirment (as % of GDP) 24.5 28.5 27.1 27.3

(Source) CRBT

Table 2: Turkey’s external financing requirement


Indeed, the underlying dynamic that these trends reflect appears increasingly troubling. Turkey’s growth model is fragile and there has been little by way of structural reforms in the country recently. The private sector’s balance sheet is becoming stretched. Yet despite this, Turkish banks and non-financial corporates have continued to enjoy access to long-term channels of borrowing. To a degree, the continued debt flows reflect Turkey’s long-term growth prospects and low base from which debt accumulation began. However, we also see indiscriminate flows that reflect cheap liquidity flowing into higher yielding investments. Indeed, though corporate sector debt is not yet at alarming levels, we still believe that the sector’s balance sheet warrants caution. Between 2007 and 2014, total corporate sector debt rose from 29% of GDP to 60%. Total FX liabilities rose from US$130.6bn in 2007 to US$272.7bn as of Q1 2015. FX assets, meanwhile, have not risen at a similar pace and amount to US$99.2bn. This brings their total net short FX position to US$173.5bn. But the important thing to point out is that the short-term portion of this total short position (with a maturity of less than one year) is only US$8.5bn (see Chart 5), a figure which is equivalent to 1.1% of GDP.

Banking sector

Just as the Turkish corporates levered up in the post-crises period, so did the Turkish banking sector, whose external liabilities rose from US$58.5bn (9% of GDP) at the end of 2007 to US$165.0bn (21% of GDP) as of 2014. Some of the hard-currency borrowing has been channeled into hard-currency lending to Turkish corporates, while the rest has been swapped into Turkish liras, then lent to Turkish households, as households are prohibited from borrowing in hard currency. As a result of this rapid credit expansion, the loan to deposit ratio rose from 80% in 2007 to 122% as of Q1 2015. The key difference between the banks and corporates balance sheet is that the banking sector does not have a sizeable short or open FX position2 (see Chart 6). The headline short FX position that is created by external borrowing is hedged off-balance sheet, principally through FX swaps, so the net open FX position for the banking sector is negligible, at around US$1.6bn (0.2% of GDP). This is not to say, however, that the Turkish banking sector is

2 This is a situation where, in this context, the FX assets of the banking sector are dwarfed by its liabilities.

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Chart 5: Non-financial corporates net FX position

Total FX position Short-term FX position

(US$ billions)

(Source) CBRT(Note) Data from 2015 is from the period January to March only.

(Year)


immune to currency shocks. The sector faces asset quality risks as it is exposed to Turkish corporates that do have a mismatch in their FX asset and liability position. Banks also face counterparty risk with regard to hedging and rollover risks with regard to their external borrowing.

Despite such challenges, the Turkish banks continue to enjoy sizeable capital buffers. While this provides some comfort, the concern is that the size of these buffers has started to fall, rather than rise, in the post-crises period. The capital adequacy ratio stood at 15.5%, as of March 2015, higher than the regulatory minimum of 12% but lower than the figure of almost 19% seen in 2007. Shareholder equity, at 10.7% of total assets, is sizeable but lower than the 13% level seen in 2007 (see Table 3).

What make of it all?

Putting all this together, we believe that banking and corporate sector balance sheets warrant some caution. It is true that the corporate sector debt is not at alarming levels and that the banking sector has significant capital buffers that could potentially absorb any adverse spill-over effects emanating from the corporate sector balance sheet. However, Turkey’s external vulnerability is large compared to some of its emerging market peers and shows little signs of moderating. In the absence of long-term structural reforms that would raise Turkey’s potential growth rate, the only way to address this imbalance is to tighten policy, be it monetary, fiscal or macro-

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Chart 6: Banking sector's FX position

On balance sheet FX positionOff-balance sheet FX position

(US$ billions)

(Note) Data from 2015 is from the period January to March only.(Source) CBRT

(Year)

(%)2007 Q1-2015

External debt (% of GDP) 9.0 21.0

Loan to depsit ratio (%) 80.0 122.0

Capital adequecy ratio (% of risk weighted assets) 18.8 15.5

Shareholder equity (% of total assets) 13.0 10.7

(Source) BRSA

Table 3: Banking sector indicators


prudential or some combination of the three. Real policy rates (calculated by using the interbank repo rate and actual inflation) have been in positive territory, but they are low relative to where inflation currently stands in the country (see Chart 7), But, that said, within the context of the country’s interest rate corridor policy, effective interest rates, such as the overnight rate, are somewhat higher (see Chart 8). Fiscal policy, although only modestly in deficit territory (1.3% of GDP as at 2014), could be tightened somewhat to tackle domestic sources of inflation and/or the current account deficit. However, given the political vacuum at the helm of government at the moment we don’t see this happening in at least in the near-term.

Going forward, the key challenge for policymakers will be to refrain from counter-cyclical easing aimed at offsetting the contractionary forces of weak global demand, tighter liquidity conditions and structurally slower emerging market growth. Such easing if delivered is unlikely to result in durably strong growth, but it could in our mind exacerbate Turkey’s macro imbalances. Beyond the near-term: Gauging the prospects of structural reforms Given the persistent nature of the problems facing Turkey we are of the view that the country needs to overhaul its economic growth model. But unlike China where the authorities are attempting to transition away from exports and investment-led growth in favour of domestic consumption, we are of the opinion that Turkey needs to do the opposite i.e. to reduce its heavy reliance on domestic sources of demand towards exports and investment (see Chart 9), with a view to moving the country up the value-added production ladder and to prevent it from being stuck in a “middle income” trap. Fundamental to such a shift is the need for structural reforms, as well as to address the country’s chronically low savings rate (see Chart 10). However, faced with a difficult political backdrop, we do not see the prospects of such reforms being realised in the immediate-term. Notwithstanding this, it is worth pointing out that, since the arrival of the AKP at the helm of government in 2002, Turkey has made some important progress in terms of macroeconomic stabilisation and enactment of certain structural reforms, which it now needs to build upon. Central to such reforms has been the improvement in the social safety net, reductions in poverty and unemployment and the taming of inflation to unlock household demand. Taken together, these measures have provided the basis for Turkey’s

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Brazil Turkey S.Africa

Mexico China Poland

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Chart 7: The differential between interest rates and inflation is modest in Turkey

compared to some other EMs

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Chart 8:...But effective rates in the country, such as the onernight rate, are rather higher

(Source) CBRT

Lower limmit


recent success. Indeed, between 2003 and 2007, GDP growth in Turkey averaged just shy of 7%, while productivity even surpassed this level. Since 2007, however, the pace of structural reforms has slowed and the economy is showing signs of pushing against its supply-side constraints. Growth has slowed and become more volatile. Labour productivity was essentially stagnant between 2008 and 2014. Leverage has continued to rise for both households and corporates but predictably it has not been channeled into productivity enhancing investments.

The previous AKP-led government was aware of the need for structural reforms and introduced a pretty comprehensive structural reform roadmap, as part of its 10th Development Plan, which covers the period 2014-2018 (see Table 4). The problem now is that political uncertainty is likely to put these reforms on the backburner. With the forthcoming election at the start of November not expected yield an outright victory for the AKP, macro issues won’t be policy priorities, especially in an environment where coalition building will once again dominate the nature of political discourse. That said, whatever the outcome to this election, we do not expect the Turkish political establishment to abandon previous reforms commitments made by the last AKP administration, though the pace of any future reforms may leave much to be desired.

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China BRICs: average Turkey

2000 2014

(Gross capital formation as % of GDP)

(Source) World Bank

Chart 9: Turkey's investment has lagged that of its BRIC peers

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China BRICs: averageTurkey

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(Source) World Bank

Chart 10:...Thanks to its chronically low savings rate

(year)

1 Increasing domestic savings2 Energy generation based on local sources3 Energy efficiency improvements4 Reduce dependence on imports5 Commercialisation of priority technology areas6 Improving the business & investment climate7 Reducing the informal economy8 Improving the effectiveness of the labour market9 Development of basic occupational skills

10 Rationalisation of public expenditures11 Raising the quality of public revenue12 Istanbul Financial Centre13 Transition from transportation to logistics

Table 4: Structural Reform Priorities in the 10th Development Plan (2014-2018)

(Source) Republic of Turkey Undersecretariat of Treasury


Conclusion Turkey has enjoyed a good run over the past 10 years or more under the stewardship of the AKP government. While this was, in large part, owing to the successful job that the aforementioned government did in stabilising the economy and improving its competitiveness, it is important to note this was also a function of the ease with which countries with external financing requirements, such as Turkey, were able to finance themselves, especially in the post-crises period thanks to the advent of QE on the part of the world’s major central banks. However, now that the domestic political environment in Turkey has soured somewhat and key central banks, such as the Fed, are looking to normalise their monetary policy settings by instigating an interest rate lift-off, this will make the going much tougher for a country such as Turkey. Against this backdrop, our take on Turkey’s prospects going forward has naturally become somewhat more cautious. That said, we expect Turkey to be able to continue to “muddle through” going forward, despite being faced with a more challenging domestic/external backdrop. This, we feel, is in large part thanks to the fact under the rule of the AKP the country has put in place a fairly sophisticated institutional framework (including for fiscal and monetary policy) which will allow its policymakers to ultimately set policy in accordance with the changing external backdrop. Additionally, it is also worth highlighting that if the AKP were to unexpectedly win a decisive victory at the November 1 election, or failing that if it was able to quickly form a coalition government with one, or more, of the other major parties, this would also help to temper some of the current uncertainties surrounding the country.

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Special Report - Turkey - Sept 2015