Turkey: Clearing Ahead

After a difficult summer, Turkey’s currency and economy show new signs of strength, restoring consumer and investor confidence.

For those inclined to write Turkey off, last month should give pause for thought. The country is hardly out of the woods, but bears are no longer so much in evidence—and there are distinct signs of a clearing ahead.

Berat Albayrak, finance and treasury minister since June’s elections (and, controversially, a businessman and President Erdogan’s son-in-law), has been quick to hail the improved mood. “Turkey’s economy is currently performing far better than in August and September,” he told Turkish businessmen in early November. “Although Turkey faced a tremendously serious operation against its currency, interest rates and inflation in August, we have defeated these economic attacks. We see improvements in the lira, credit default swaps and loan interest,” saying that swift and well-coordinated government action has played a role.

What’s the evidence? Well, Turkey’s €1.5 billion ($1.7 billion) international eurobond offer in early November—sold at a yield of 5.25%—was three times oversubscribed, with some 200 institutions vying to take part; moreover, some 55% of the offering was taken up by investors in the UK and US, suggesting they are no longer shy of investing in Turkey. Given Turkey’s strong dependence on wholesale external financing, this is an enormous relief.

“There had been concerns whether banks would be able to roll over funding,” says Istanbul-based Roger Kelly, regional lead economist at the European Bank for Reconstruction and Development (EBRD). “Although pricing has been higher, so far they haven’t had any problems.” He says concerns have shifted toward solvency, particularly for smaller banks with big exposure to the real estate/construction sector.

Garanti and Isbank have reported nonperforming loans (NPLs) rising to 3.9%, with the average currently at 3.2%, against 2.95% at the end of 2017. With some fearing that Turkey’s historically low NPL ratios could rise above 10% by the end of 2019, banks are deleveraging, which will contribute to economic slowdown.

“Though we expect net new lending to contract sharply as banks move to protect balance sheets, the sector remains well capitalized, robust and well regulated,” says Kelly.

Strengthened bond and equity markets are bolstering the turnaround. The lira has recovered dramatically. After plummeting by 40% versus the dollar in August, it reached a historic low of around 7 Turkish lira; as of mid-November, the rate had rebounded over 5 lira. Though well down from the end-January 2017 rate of 3.75 lira, it is better than anyone hoped in the dark days of summer, suggesting that the Central Bank’s decision to hike interest rates to 24% has had the desired effect. Still, investors remain wary about government meddling in the central bank’s decision-making.

“The improvement in the exchange rate, rapprochement with the US and Washington exempting Ankara from sanctions on oil imports from Iran (a significant source of Turkey’s energy imports) have all supported a modest return of investor confidence reflected in the improvement in the exchange rate,” Kelly says.

Finding a New Balance

He and other observers agree that one of the upsides of the summer crisis has been a rebalancing of the economy, as domestic consumers hold back on spending and the lower lira depresses imports and boosts exports. This change is already being reflected in the current account, which in September showed a surplus of $1.83 billion, compared to a deficit of $4.4 billion in September 2017, according to Focus Economics. Tourism has seen a big recovery, with more than 40 million visitors expected by the end of this year and almost 50 million next, according to Minister of Culture and Tourism Mehmet Nuri Ersoy.

“The falloff in domestic consumption has opened up capacity for export-focused businesses to take advantage of Turkey’s improved competitive position,” says Jason Tuvey, analyst at Capital Economics. Tuvey says Turkey’s large manufacturing sector can take advantage of domestic-currency weakness, especially with capacity utilization now at its lowest level since early 2015.

However, he says the country still faces significant short- and medium-term challenges, not the least of which is a hard landing, with GDP growth turning negative next year. Inflation—currently at a 15-year high of 15% to 25%, depending on the source—is expected to remain a big challenge.

Forecasters are divided over how far they feel GDP will be impacted: Capital Economics expects a contraction of 0.5% for the full year. Fitch Ratings, which downgraded Turkey this summer, anticipates a contraction of 1.9% in 2019 with GDP recovering to grow 3.9% in 2020, with its public debt profile remaining good (net external debt, at 37.2%, remains very low compared to other emerging markets and even some developed ones). The EBRD expects growth to slow to 1% next year, from around 3.6% this year, as higher interest rates and lower bank lending depress activity in the domestic economy, but inflation is expected to moderate as demand-push factors ease.

“Any sector driven by domestic consumption, including white goods and cars, will be hit hard,” says the EBRD’s Kelly. “Also, because many exports are priced in dollars, some sectors won’t feel the benefit of the weaker lira.” Kelly expects a U-shaped recovery rather than the V-shaped one Turkey normally experiences when recovering from recession.

The government also advances economic rebalancing through close involvement in China’s Belt and Road Initiative (BRI). Some local BRI projects are part of Turkey’s New Economic Program, which is partly aimed at boosting infrastructure investment. “Turkey supports the development of regional transportation projects, as it has parallel aims,” says Arda Ermut, head of the Turkish Presidential Investment Office. “Turkey has been an important partner of the Middle Corridor Initiative, which passes through Central Asian republics, Afghanistan and Pakistan to China.”

Other big projects include energy works and Canal Istanbul, a new waterway connecting the Black Sea to the Mediterranean. In mid-November, Russia’s President Putin attended a ceremony to mark completion of a section of the TurkStream natural gas pipeline, which will deliver natural gas from Russia. Meanwhile, foreign direct investment (FDI) inflows—though well down on a few years ago—have held up better than expected. “Turkey has attracted more than $8 billion in the first nine months of 2018,” says Ermut, noting that its strategic location and young, well-educated workforce remain magnets.

“Our location provides investors easy access to lucrative markets around Turkey, with combined populations of around 1.6 billion people and $24 trillion,” he points out. “Around half of global trade takes place within a four-hour flight radius of Turkey.”

Most observers agree 2019 will be a tough year. With voters facing tougher times, the governing party’s share of the vote is likely to fall. However, investors will be looking to Ankara to resume reforms. “Investors continue to view the government skeptically,” says Tuvey. “It is really up to Ankara to dispel these doubts and prove it is serious about reform.”