September 2009

DenizBank Political & Economic

Update

Turkey

Politics…

A new phase in Turkish foreign policy

Economy…

The economy has turned the corner in 2Q…

…but recovery loses steam

Correction in current account balance lingers…

…while capital account balance worsens further

Benign inflation supports CBT’s easing bias

2

DenizBank Political & Economic Update

Politics

A new phase in Turkish foreign policy… In the last decade, Turkey’s role as a regional power held sway over a large geographical area from the Middle East to the Central Asia. Turkey has long been playing a key role in the resolution of international disputes as a peace-promoter in the neighboring regions. But a new phase has also begun in Turkish foreign policy since AKP’s second term and the recent appointment of Foreign Minister Davutoglu as Turkey began to address her own chronic problems with close neighbors. Particularly regarding Armenia and Southern Cyprus, reconciliation gained momentum lately. Early September Turkey and Armenia moved closer to establishing diplomatic relations and reopening their border when they issued a joint statement giving themselves six weeks to complete accords aimed at ending nearly 100 years of animosity. Before the Switzerland mediation, they have never had diplomatic ties while the border has been closed since 1993, when Armenia and Azerbaijan went to war over the enclave of Nagorno- Karabagh. Turkey was on Azerbaijan’s side in the dispute; however Russia’s military action in Georgia last year highlighted the security concerns in the Caucasus and pushed Turkey to seek to improve ties with its neighbors in the region. An Armenian reconciliation could serve Turkey mainly in two ways. First, eventual opening of the border will benefit the Turkish economy through revitalized trade flows. Currently, there are limited charter flights between them but no real trade. Second, improving relations with Armenia could improve Turkey’s chances for admission to the European Union. The next round of talks will take place in mid October, ending about the time of a World Cup qualifying football match between Turkey and Armenia in Istanbul. Recently, Prime Minister Erdogan underlined that the talks between Turkey and Armenia have entered a sensitive phase. The protocols between two nations will be sent to the parliaments next month. As for the Southern Cyprus issue, it has become inseparable from Turkey’s accession process to the EU. After the Greek side of the Cyprus’ (“Southern Cyprus”) EU accession, Turkey’s relation with the EU became more problematic. Peace talks began last year with the support of Turkish government, aiming a settlement similar to that proposed in the Kofi Annan plan rejected earlier by the Greek side. It had proposed an establishment of a bi-zonal, bi-communal federation between Greeks and Turks. Turkey was also asked to open its ports to the 10 new EU member countries including the Greek side of Cyprus. Since Turkey did not open its ports due to EU’s noncompliance with its promises to lift the bans over the Turkish side of the Cyprus’ (“Northern Cyprus”), the European leaders froze eight chapters in 2006. They further decided not to move ahead on other chapters until Turkey opens its ports and airports to traffic from Southern Cyprus. Now, the EU seems willing to revive a proposal which is based on opening ports to Greek shipping in exchange for opening the Ercan airport in Northern (Turkish) Cyprus to international air traffic coupled with direct trade with Northern Cyprus. Turkey is working hard to find a permanent solution for the divided island by mid-October. Given this backdrop, Turkey has supported Northern Cyprus’ constructive efforts in the recent Cyprus negotiations which have started on September 11

th. A failure of

the Cyprus negotiations is less of a problem; it could result in a breakdown in EU-Turkey relations but they are not proceeding well anyways. On the other hand, a deal to be reached will achieve big; it will allow the whole Cyprus to thrive economically with a wider regional stability and will improve prospects for Turkey’s EU bid. The efforts regarding the Armenian and Cyprus issues in addition to Turkey’s efforts to strengthen its relationships with Greece, Iran, Iraq, Syria, Israel, the Palestine and Russia will facilitate Turkey’s emergence as a regional superpower. Having a history going back to the Ottoman Empire, the 17

th largest

economy in the world, the biggest army of Europe, the only true secular democracy among Moslem countries will enable Turkey to easily become a regional superpower. If these issues are successfully resolved then Turkey could boost its prestige as domestic reformer (Please refer to DenizBank Monthly –July 2009 for further information) and as regional peace-maker. The prospects are bright with or without the EU.

September 2009

3

Figure 1:

Real GDP Growth (YoY % change)

-14.3%

-7.0%

-6.5%

-15%

-10%

-5%

0%

5%

1Q05 1Q06 1Q07 1Q08 1Q09

Quarters 4-quarter rolling

Figure 2:

Private Consumption Growth (YoY % change)

-1%

-10%

-4%

-12%

-8%

-4%

0%

4%

8%

12%

1Q05 1Q06 1Q07 1Q08 1Q09

Quarters 4-quarter rolling

Economy

The economy has turned the corner in 2Q… National income figures announced in early September confirmed that the economy bottomed out in 1Q09 and then has begun a recovery –though modest- since then. Turkish GDP contracted by 7.0% in 2Q09 (compared to the corresponding quarter a year ago), a more moderate decline than that of the 8.2% consensus. The figure turned out to be a rebound as well from the preceding quarter record-low growth at -14.3%, which had brought the economy towards the top of the global contraction ranking. This was hardly a surprise given that the GDP growth rates in 4Q08 and 1Q09 were revised down to -6.5% (from -6.2%) and to -14.3% (from -13.8%), respectively. On a four-quarter trailing basis, real GDP contracted further by 6.5% in the second quarter following the 4.1% decline in 1Q09 (Figure 1). Apart from the relative quantitative improvement achieved in headline figures, the compositional aspect of growth in 2Q09 was very similar to those in 1Q09 indicating that the economy has not yet returned to normal. The fall in private spending and inventory depletion trimmed the headline growth while the rise public spending and the stronger net exports (a greater fall in imports than exports) contributed to it. Without a doubt, the stimulus measures, especially tax reductions, played a pivotal role in the upturn in 2Q09. The economy is heavily dependent on private consumption, which accounts for 70% of GDP. On the back of the exceptionally weak first quarter, retail sales exploded in 2Q09 due largely to the tax relief on cars and consumer durables. Private consumption expenditures dropped by only 1% (compared to the same quarter a year ago), following a whopping 10% plunge in 1Q09 (Figure 2). The impact of private consumption expenditures was only -0.8 percentage points in 2Q09, compared favorably with -7.3 percentage points in 1Q09. On the other hand, there was little improvement in investment spending if at all. Private investment spending shrank by a massive 30% annually (following a 34% drop in 2Q09) and dragging the headline growth down by 6.4 percentage points. If it is any consolation, investment spending was dire rather in construction than machinery but the latter was not promising either. Actually, decelerating investment appetite, which is likely to haunt the economy in productivity in the quarters ahead, had started much before the current crisis. Growth rates in private investment spending were the highest among sub-segments during the boom years, hovering around 20% levels, but since the beginning of 2007 it had been moving on a decreasing trend.

September 2009

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DenizBank Political & Economic Update

Economy

Table 1:

Turkey's Real GDP Growth Forecasts

(%, YoY) 2009 2010 2011 2012

Government (with MTP) -6.0 3.5 4.0 5.0

IMF -5.1 1.5 4.0 3.5

World Bank -5.5 1.5 3.0 na

OECD -5.9 2.6 na na

Back to the headline figures, seasonal adjustments made by the TURKSTAT point out that the GDP grew by an extremely strong 7% quarterly in 2Q09, marking the technical end of the four-quarter recession (Figure 3). Actually, what set the recent one apart from previous slumps was not its length, but its depth. Producing a 13% cumulative melt down between 2Q08 and 1Q09, the recent recession was the deepest since the WWII. The intensity of the plunge can also be better understood when compared with the last crisis in 2001: the cumulative contraction in seasonally adjusted GDP was only 11% between 1Q01 and 4Q01. The marked upturn in 2Q09 looks very similar to the steep rebounds following the past crises. However, whether this recovery will be sustained is still uncertain, for the moment. The supporting factor is that there has been no valid reason to assume a permanent weakness in the economy's demand potential, which roars back to normal after the confidence is back upon bottoming out. In fact, enjoying relatively unleveraged consumers, healthy banks and historically low interest rates, the economy has been ever more ready for a domestic growth-led revival at the moment. On the other hand, there are also counter factors for sustaining the recent buoyancy. One is that the fiscal stimulus which lifted the spending recently will soon fade out as also supported by the recent flow of data. Also, foreign funding sources are far from being supportive to the Turkish economy that is structurally dependent on foreign funding to grow at its potential (or at least at a pace that decreases unemployment) unlike the prior recessions. The consensus is that the pace of global growth in the coming quarters will only be moderate, less than one may expect given the depth of the recession, because of the ongoing headwinds. The short-term outlook of the Turkish economy has also become less upbeat lately. Even the government seems less bullish on growth. After months of delay, the Medium Term Programme (MTP), which contains the administration’s three year economic action plan, was revealed in mid-September. The government significantly revised down its growth target for 2009 to -6%, from its previous -3.6% assumption. Naturally, following the dismal 11% 1H09 contraction, the revised target was perceived as more realistic and doable by the markets. For the years ahead, assuming a scenario of weak global economic growth (and a Euro-area growth estimate at zero for 2010), the MTP expects the Turkish economy to grow 3.5% in 2010 and to near its trend growth with 5% as late as 2012 (Table 1). On the other hand, assuming global trade and capital flows to remain significantly below the previous decade’s highs, leading international institutions looks more bearish on Turkey over the next few years. The IMF, for example, forecasts a mere 3.5% growth (nearly half of her potential growth rate according to most conventional estimates) for 2012.

September 2009

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DenizBank Political & Economic Update

Economy

Figure 4:

Industrial Production Growth (YoY change)

-9.2%

-23.8%

-14%

-28%

-21%

-14%

-7%

0%

7%

Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09

12-m rolling

Figure 5:

Capacity Utilization Rate in Manufacturing

69.7%

72.7%

63.8%62%

66%

70%

74%

78%

82%

Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09

Jun-09

Aug-09

…but recovery loses steam A recovery, as discussed above, began in 2Q09. A strong push of fiscal and monetary stimulus lifted domestic spending while business and consumer confidence revived. However the real challenge stretches into the second half of the year. The question that economists have tried to answer lately is whether the expansion have gained enough momentum to continue once the adrenaline rush of lower interest rates and big tax cuts ebb. The common view has been deteriorating: the economic administration and the central bank as well as most market participants have become increasingly cautious about the persistence of the recent upturn. Indeed, recent evidence does not favor a positive outcome. Latest readings on industrial production, capacity utilization, confidence and domestic sale indicators imply that the economy might display a weaker course in the third quarter. Industrial production contracted by 9.2% in July compared to the same month a year ago. The rate of annual contraction in production, which reached as high as 23.8% in February, has been decreasing ever since (Figure 4). But this time, the improvement in annual growth figure remained subdued compared to those secured in the previous couple of months. Particularly, the -10.3% figure for June, following the -17.3% of May, was much more welcomed by markets. The contraction in July, however better than before, was not perceived as a promising start to the third quarter in terms of growth and provides little evidence in favor of a strong recovery argument. Seasonally adjusted industrial production figures depict an even more discouraging picture. The Turkstat’s index adjusted seasonally and for calendar effects suggest that production has been at a standstill since the beginning of the year, only a very limited improvement secured after April. The June’s adjusted reading is yet to be announced, but according to our calculation, it is unlikely to show a monthly increase. Adding more to the cautious stance, the capacity utilization rate for manufacturing decreased from 72.3% in July to 69.7% in August, registering the second consecutive monthly decline following a partial recovery trend in 1H09 (Figure 5). August is conventionally a month of respite and a strong seasonal force pulls capacity utilization rates down. However, historical data suggest that capacity utilization improves even during the months of August while recovering from a crisis which did not happen this year.

September 2009

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DenizBank Political & Economic Update

Economy

Figure 7:

Confidence Indices

50

60

70

80

90

100

110

Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09

Consumer

Real Sector

Optimism

threshold

Figure 6:

Domestic Automobile and White Good Sales (2007 avg=100)

0

50

100

150

200

Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09

Tax

cuts

effect

White

Goods

Automobile

For that reason, the 2.6 percentage points drop in this year’s August is not promising, yet suggests some slowdown in the pace of the recovery. Capacity usage has been perhaps one of the most pessimistic figures with respect to growth. Fast capital formation proved useful during the 2002-2008 period, where the capacity utilization rate averaged 80%. But those heady years left the manufacturing industry saddled with more capacity than can be absorbed during this recession, and the rate fell to 64% early this year, marking the lowest level on record. Over-investment is now impeding an economic revival and a relief in unemployment. Firms that cannot justify new capacity as they already have nearly one third of their capacity sitting idle also are hard-pressed to rationalize adding jobs. On the other hand, lower capacity utilization is helping to prevent inflationary pressure from taking hold in the economy. The recovery in 2Q09 was driven by rebounds in automobile and consumer durable sales. Thanks to the price incentives provided by the fiscal package in March, sales were exceptionally strong until June with the backing of reduced taxes. The data releases since then showed a substantial retreat. As per August, domestic automobile sales were down to its early-2009 lows. Domestic white goods sales headed down, too, though the severity of the decline has not been as discouraging as that in automobile sales (Figure 6). Given that the tax cuts are set to expire entirely by the end of September, the prospects for domestic sales remain hazy. In our view, the stimulus measures pulled forward a significant amount of future demand hence both white goods and auto sales in 4Q09 might end up even lower than in 3Q09. The upward trend in consumer and business confidence has been reversed lately, indicating a durable change in perception is absent. After surging seven consecutive months, the consumer confidence index had edged down in July. The fall extended in August. Real sector confidence deteriorated as well in August and September, following seven monthly increases in a row (Figure 7). Both indices are hovering under the optimism threshold. Given this background, the picking up of economic activity in 2Q09 may not repeat in the second half of the year. Uncertainties for a V-shaped recovery with a rapid return to growth have risen.

September 2009

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DenizBank Political & Economic Update

Economy

Figure 8:

Current Accounts Balance (% of GDP)

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

89 91 93 95 97 99 01 03 05 07 09F

'94 '01

'98

Figure 9:

Current Account Balance (12-m rolling, USD bn)

-16

-30

14

-50

-40

-30

-20

-10

0

10

20

97 98 99 00 01 02 03 04 05 06 07 08 09

Energy

balance

CA Balance

Non-energy balance

Correction in current account balance lingers… If there is a common symptom plaguing emerging economies in times of global financial troubles, it is the scarcity of foreign funding. In the current crisis, virtually all emerging nations experienced an exodus of foreign capital. The pain has been greater for those emerging economies that have recently experienced a current account deficit. Evidently, the severity of GDP declines was significant in Eastern Europe (to some extent, in Latin America too), which suffered the largest capital outflow. For Turkey as well, large external deficit has been the most important factor exacerbating the damage of the global crisis to the economy. But the crisis came with its welcomed side-effects too. One of them is a quick correction in external balances, which was also the case in Turkey during the previous crises. Both foreign trade and current account deficits have been declining rapidly since September 2008. On a 12-month rolling basis, trade deficit and current account deficit plunged to $43 bn and $16 bn as of July, compared to their August 2008 peaks of $76 bn and $49 bn, respectively. The current account balance to GDP ratio, which was hovering around 6% after 2006, dropped to 3% as of June 2009 and is expected to fell further below 2% at the year-end (Figure 8). The improvement in current account balance from its peak is a result of an equal amount decline ($33 bn) in trade deficit while the surplus in other items (services and income balances) remains nearly unchanged. The $33 bn fall in trade deficit is attributable to repercussions of the crisis. Firstly, Turkey is an energy importer and the fall in oil and natural gas prices -thanks to waning global demand- came as a relief. The net energy balance posted a $30 bn deficit in the year to July versus a $40 bn deficit in August 2008, suggesting that $10 bn of the improvement came from the energy bill (Figure 9). Secondly, domestic consumption and investment appetite have been falling, causing non-energy imports to drop faster than exports. This leads the non-energy balance to improve even more rapidly ($23 bn) during the aforementioned period. The currency depreciation early this year may also have been supportive for the correction in external balance as the weaker TL prompted some local manufacturers to use domestic intermediate goods rather than imported raw materials, evident from the fact that the fall in intermediate goods imports has exceeded that of exports lately.

September 2009

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DenizBank Political & Economic Update

Economy

Figure 11:

Capital Infows (FDI+Portfolio+Credit)(Annual, % of GDP)

-3%

-1%

1%

3%

5%

7%

89 91 93 95 97 99 01 03 05 07 7M09

Figure 10:

Corporates L-T External Debt Roll-Over Ratio (Monthly)

0%

100%

200%

300%

400%

500%

06 07 08 09

YTD

weighted

avg. = 73%

Bu the correction will not last for good. Following the collapse in 2H08, oil and other energy prices have increased, though very slowly, since 2Q09. Starting from 4Q09, this would slow any further improvement in the trade balance given Turkey’s well-known energy import dependence. Manufacturers’ substitution of imports with domestic goods is unlikely to continue being supportive as the TL reversed part of its fall early this year and remains stabile for quite a while. Yet, the main determinant for the extent of the correction will be the course of domestic demand. Even though investment appetite is likely to take some time to restore, consumption demand has bottomed out and a recovery –though a slow one as we emphasized- is underway. Putting all together, we expect the current account deficit to continue to narrow throughout the year and stabilize around $10 bn level in early 2010. Once the economy starts to regain its speed, which may well fall in 2010, the deficit will heads up again, barring an extraordinary structural macro transformation.

…while capital account balance worsens further… Back in the aftermath of Lehman’s fall last year, the primary cause for concern was that the two major crises that Turkey faced in 1994 and 2001 were preceded by high current account deficits resulting in external financing difficulties, capital outflows and in turn currency runs. In some sense, what was anticipated took place and the global crisis has also affected Turkey through financial channel in form of a decline in external capital flows. Foreign direct investment has declined since 2008 while portfolio flows have been broadly negative since mid-2007. As the corporate sector has become net payer since early this year, external credits -the main financing item- also turned negative. Actually, the sector copes with its external debt quite better than initially expected. The repayment of the sector’s long-term external debt falling in the first seven months of 2009 amounted to $17 bn. The debt roll-over ratio averaged a substantial 73% (Figure 10), far from ringing alarm bells, especially given the absence of appetite for fresh investments. The roll-over ratio for domestic banks was a bit lower at 56% during the period but it did not reflect their inability to reach external funding; just a lack of interest as funding was costly and the demand for loans (usage of funds) was on the wane. As a result, capital outflows reached 0.5% of GDP (-$4 bn) in the year to July (Figure 11). Going forward, capital outflows is unlikely to be reversed in short term. A simple iteration of existing trend suggests that outflows may reach as high as 2% of GDP, a level similar to those recorded in 1994 and 2001 crises.

September 2009

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DenizBank Political & Economic Update

Economy

Figure 12:

Net Errors-Omissions (Monthly, USD bn)

-4

-3

-2

-1

0

1

2

3

01-07 06-07 11-07 04-08 09-08 02-09 07-09

Total inflow =

USD15.5 bn

Outflow s

Inflow s

Figure 13:

CPI and PPI Inflation (YoY, %)

-1.0%

5.3%

-5%

0%

5%

10%

15%

2006 2007 2008 2009

PPI

CPI

Year-

end

target =

7.5%

As described above, even though its magnitude has been declining, Turkey still posts current account deficit (annually $16 bn as of July) while capital flows turned negative (annually –$4 bn as of July). In normal circumstances, the $20 bn gap should have been filled by the change in official reserves for the mentioned period. Nonetheless, the run-down in CBT’s official reserves amounted only to $5 bn (on 12-month cumulative terms). The most recent figures show that official reserves were $70 bn, below its all time high at $78 bn recorded in May 2008 however still strong enough to cope with a currency run. Besides running down the official reserves, the remaining lion’s share ($15 bn) was funded by unidentified inflows through net errors and omissions account. Put differently, unidentified inflows have been the main financing item since last October and have prevented weakening in the local currency. Between October 2008 and June 2009, the cumulative unidentified inflows reached an extreme $15.5 bn (Figure 12). Residents, especially business owners, which repatriate money from abroad to take advantage of the tax amnesty scheme or to help their businesses to roll-over debts, may well be behind these inflows. These also help explain the relatively high external long-term debt roll-over ratios of the corporate sector. Barring a nearly $1 bn outflow in July, the persistency of flows has been so strong that it points out some systematic under-recording, limiting the risk of a sudden stop or even reversal, in our view.

Benign inflation supports CBT’s easing bias… Consumer prices fell by 0.3% in August, while the consensus was a rise of 0.2%. This corresponds to a fall in annual inflation to 5.3% from 5.4% a month ago (Figure 13). What matters the most with the August release, is the fact that the fall in annual figure came despite adverse impacts of the recent tax and administered price changes and the well known Ramadan on food prices. Indeed, the -0.3% reading was extremely low for the month of Ramadan from a historical perspective. Moreover, core inflation is also benign: most special indices, including the CBT’s favorite (I) index, improved compared to July. Services inflation continues to edge down as well.

September 2009

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DenizBank Political & Economic Update

Economy

Figure 14:

Bond Yields vs Policy Rate (Compound annual rates)

8,9%

5%

10%

15%

20%

Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09

Benchmark Bond Yields

CBT Policy

Rates

O/N: 7.25%

(Sep.25)

By all means, the recent trend in consumer prices is a significant sign of lack of domestic demand pressures. Cost-push inflation pressure is weak as well. The annual producer prices inflation edge up a bit in August, but is still on a negative territory. Weak consumption demand conditions also prevent businesses to pass on higher costs to their final prices; instead they seem to sacrifice profit margins. Going forward, the complete expiration of the Special Consumption Tax (SCT) cut and the hike in electricity prices coincide in October. However, the base effect is high enough (2.6% in October 2008) that will likely offset these effects. Put together with signs of weakening in the recovery started in 2Q09, inflation should not spiral out of hand in the short term. Instead, the annual rate is likely to fall below 5% mark (another record low) until November. In any event, inflation will certainly remain far below the official 7.5% target. Following an era of chronic inflation, with 35 years of double or even triple digit figures, annual rates hovering around 5% level should be taken as a success, without a doubt. But it is too early to say that the fight with inflation is won, in our view. Once the economy regains its potential growth rate, the whole picture may be reversed. In September, the Central Bank cut the policy rate by another 50 basis points to 7.25%, a new historic low. There was nothing unforeseen about the decision as the market was almost unanimously expecting a 50 basis points cut. The cuts since November totaled 9.5 percentage points, highest in the emerging world by wide margin. The surprise, in some sense, came from the accompanying statement. The dovish rhetoric was maintained with a strong tone, and the Bank signaled more cuts to come. The view that the current recovery in economic activity is gradual and protracted strengthened, and inflation prospects still seem to remain benign for a long period of time. The surprise part is that there are no indications of a possible pause or of smaller step cuts, whereas most economist were expecting (before seeing the latest statement of course) the cycle to end with a final 25 basis points cut in October. Now, most pulled their expectations for the terminal rate down towards 6-6.5%. Another crucial point with the monetary policy outlook is the new sentence added to the statement saying that further improvements in the risk premium may lead the central bank to continue rate cuts. Coinciding with the announcement of the Medium-Term Programme (MTP), it is clear that the message refers to the government’s efforts to restore public balances and their repercussions in markets. The first impression on the long sought MTP was quite positive. The IMF found it encouraging while two rating agencies revised the outlook for the sovereign rating upwards (S&P to “stable” from “negative” and Moody’s to “positive” from “stable”). All of these support the CBT's easing bias. Another 50 basis points cut in October is the most likely outcome and a couple of further cuts is likely to follow, in our view, but their size will depend to both global and local developments. Although the most recent cut of 50 bps was totally discounted in the markets, the dovish tone of the statement together with greetings on the MTP resulted in another fall in bond yields in mid-September. The benchmark bond yield eased below 9% annually compounded, to another historical low (Figure 14). For the months ahead, the benchmark bond yield may ease further to 8% as the light redemption schedule of the Treasury for the 4Q09 seems supportive.

September 2009