Turkey Investment Case: How to Keep it Intact?

Soon after the collapse of the Lehman Brothers in September 2008, the first reaction that the emerging markets got was not pretty.  Even though crisis originated in the US markets, rest of the world including emerging markets was largely hit.  Yet, despite all the volatility in 2008 and 1H2009, what the markets call the decoupling scenario occurred in the latter half of 2009: Overwhelmed with the burden of public sector debt, growth in the developed countries were expected to be slow whereas most of the EM had healthier fiscal balances, leaving the ample room for faster growth backed by their demographic advantage.  Real growth rate differential between the developed and emerging markets changed investor sentiment dramatically in favor of the latter.  FED’s monetary policy also created an interest-rate differential, facilitating flow of funds to EMs.

Turkey’s investment story fitted very well into this change of mindset regarding the emerging markets.  Turkish market was one of the worst hit following the few months after Lehman’s collapse.  Yet, domestic demand recovered fast, fuelled by capital inflows starting with second half of 2009.  Drivers of Turkey investment story were:

1)   Healthy financial sector: One of the highest ROEs in the world with clean balance sheets. After the 2001 crisis, sector was recapitalized, restructured and closely monitored by BRSA.

2)   Prudent fiscal policy: Again as a result of 2001 crisis, there has been public sensitivity for budget figures in Turkey.  After 4-years of very tight fiscal policies, public debt came down from 80% of GDP to 40% level in 2008.  Even the contraction in 2009 did not take the debt level off route.  Turkey was one of the few countries in the world, which had a declining debt level in post-Lehman era.

3)   Favorable demographics: Given the aging population in the developed markets, emerging markets are attractive for their young population.  With the recent increases in income, most emerging markets provide a large pool of middle-income consumers, providing a potential for growth for companies.  With its demographic structure and growth in its GDP/capita in recent years, Turkey has been in the radar of international players who wanted invest in the EM middle-income story.

Turkey was additionally favored because of the domestic political stability, which had been traditionally listed as Turkey’s main risk factor in the 1990’s.  Turkey’s risk indicators improved dramatically in this environment despite the significant widening in the current account deficit and above-EM average inflation rates.  As capital inflows surged, real rates in Turkey, which had been one of the highest in the world along with Brazil prior to 2008, fell from an average of 8% to 2% in the post-Lehman period.

As the EM Story Changes Once Again…

Over the past three months, there have been an increasing number of articles questioning whether the ‘EM paradise is over’.  Developments in the global economy since the beginning of 2013 have been indeed critical for the EMs.  Particular problems in Chinese and Indian economies along with QE tapering have raised the question whether the growth differential between developed and EMs can remain as high as before.  Additionally, slower growth in China caused commodity price forecasts to be revised downwards, further increasing the concerns regarding the growth rate of commodity exporters such as Brazil, Russia and South Africa.  As global risk aversion changes directions once again, the EM story does not sound as attractive as before to investors.

Part of the sentiment change towards EMs is very likely to be a result of procyclical herding behavior^1[1].  As Raghuram Rajan wrote recently, talking about India, there seems to be bipolar behavior in assessments of EM economies with analysts swinging between over-exuberance and flagellation^[2].

While factors such as low public debt and growing middle income classes are strengths that would not evaporate away overnight, cyclical downturns due to QE tapering are likely to drag EM short-term growth down.  Further more, such downturns are likely to be higher in countries, which benefited the most from capital inflows, such as Turkey.  BBVA Research calculates excess capital into EM pushed by QE3 by May 2013 as USD 215bn^[3].  Until the excessive capital completely outflows from EMs, we are likely to see volatility in these markets.  As EMs overall and Turkey in particular have sound financial systems and lower levels of public debt compared to 1990’s, in Andres Velasco’s words ‘the question is not whether EM financial sector will implode, but whether their growth trajectories will implode’^[4].

Sources of Volatility for Turkey

Despite global sources of volatility, each country has its own unique set of conditions, which will determine the magnitude of volatility in its markets.  How the policy makers play to the strengths and weaknesses of their countries determines the impact of volatility on their long-term growth.

In Turkey’s case, there are unique issues, which can increase the volatility; hence the growth rate:

1)   Monetary policy: CBT is often cited as following unorthodox policies. CBT’s insistence on verbally intervening to the markets and its distance to conventional monetary tools is creating a credibility gap at the disadvantage of TL compared to other EM currencies.  Turkey’s higher than EM average inflation is not likely to help either during these turbulent times.

2)   Current account deficit and real sector short positions: Having run an average current account deficit of 7.3% in the last three years, Turkey has become vulnerable to volatility in international capital flows.  Since 2007 Turkey’s real sector has tripled its short-position to almost USD 165bn by mid-2013.  Even though the strength of the real sector usually surprises on the upside, three-month volatility of TL is a critical factor for the corporate sector balance sheet due to input-output structure of most sectors.

3)   Domestic political stability: As mentioned above, the AKP government has been praised for bringing political stability in the past ten years.  Yet, the reaction of authorities to the recent social protests and the upcoming election period are creating concerns whether there might be increasing turbulence in domestic political scenery.

4)   Middle East and foreign policy: With political stability of the past ten years, Turkey had been often cited as an Islamic role model for the region (even though I’ve personally thought there is an oxymoron in a secular state being an Islamic role model). Yet, the increasing turbulence in the region is putting Turkey in a very hot spot.  A lot will depend on the degree of Turkey’s involvement in the Syria conflict and how the issue is resolved internationally; yet the argument that Turkey is a role model for region, has been losing ground in the past few months.

While these issues are likely to increase the volatility in Turkish markets, there are upside potentials for decreasing the volatility as well.  Recent polls are pointing out that Turkish exporters are getting optimistic on future orders due to recovery in EU markets.  While commodity exporters are likely to suffer from the recent global picture, Turkey is likely to benefit from the EU growth recovery.

Last but not least, Turkey can still play its sound fiscal policy card.  During 2008-2009, fiscal picture helped Turkey weather the storm.  Despite the upcoming election period and slowing growth, government officials publicly announce their commitment to domestic debt sustainability. Their track record should make investors give them benefit of doubt specifically in this area.

Turkey’s Ability to Build an Investment Case

Once the excessive flows are out of the way and cyclical downturn is over in EMs, policy choices around the fundamental strengths and weaknesses will determine the long-term growth potential. Policies aimed directly at productivity increases will help to avoid the middle-income trap and cause countries to differentiate.

Despite cyclical downturn disadvantages, Turkey’s long-term growth is likely to be determined by its ability to build a long-term investment case based on productivity as well.  In this respect, there are four acute areas where clever policy choices can make a significant difference in Turkey’s potential growth rate and hence in its investment story.

1) Middle-class productivity: Experts argue that one of the current government’s success in the last ten years was economically including the Anatolian middle class into the global economy.  Last few years’ export diversification success was mainly attributed to the increasing contribution of this class into Turkey’s economic life.  Additionally some argue that integrating the urban poor into low quality service sector jobs benefited both the AKP and the Turkish economy^[5].

Yet, with one of lowest contribution per worker rates, Turkey has to implement policies to channel low-wage producers to highly skilled and fast-moving innovators^[6].  As the service sector is increasingly characterized as tradable and the new driver of growth, clever policy choices to increase service sector labor productivity can make Turkey’s investment story stronger.  In this respect, Turkey’s investments on education, skills, R&D; basically fundamental capabilities in Rodrik’s terminology^[7], should be more closely monitored.

2) Political inclusiveness: In a recent article, I have argued that Turkey’s income indicators (as calculated by GNI per capita) increased faster compared to most of the other economies in the past ten years^[8].  Yet, governance and social indicators were not able to catch up with growth performance.  The lag between the indicators, similar to Huntington’s lag terminology, was used by M. Naim^[9] in explaining the protests in Brazil and Turkey: ‘The primary problem of politics is the lag in the development of political institutions behind social economic change’.  Other countries experiences show that there cannot be a significant lag between the indicators; they converge in the long-term.  Hence, Turkey’s growth performance may only be sustainable if political institutions become more inclusive and/or fundamentals get stronger.

Accepting the recent protests in Turkey as the demands for a pluralistic approach in Turkey, there is a chance that the country can fast-track on political inclusivity given that appropriate policy reaction is taken.  In other words, protests give an opportunity to policy makers to make growth performance more sustainable.  Authorities reaction so far, has not been very supportive of this scenario working out; but window of opportunity is still open.  What government will propose in the ‘democratization package’ will be of crucial importance.

3) Peace Process: After the 30-year chaos in the South Eastern Region of Turkey, the government has taken steps to actually allow peace to settle in the region.  The process is not going smoothly and there will likely to be a lot of ups and downs; but the acute probability that there is settlement means a lot, not only for the region but also for Turkey’s overall macroeconomic performance.  Given the huge difference in the economic and social indicators of the Region with the rest of Turkey, any normalization process can have positive contribution to Turkey’s potential growth rate^[10].

4) Female Labor Participation Rate: The difference between the economic and social inclusion of economic agents into Turkish economy does not only occur on a regional basis; but also between the sexes.  In Turkey, male labor participation rate stands at 72% as of May 2013 compared female ratio of 32%.  Turkey can increase its growth potential by lifting up the overall labor participation from the current 52%; but that option seems to be viable by only increasing the female labor participation rate.  In a recent study, Asik from TEPAV shows that only by the increase in female labor participation rate, national income can increase by 20% by 2023^[11].

Conclusion

The recent events in global economy show that EMs are in a cyclical downturn in their growth rates.  With pro-cyclical behavior of financial markets, sentiment towards countries with external vulnerabilities, such as Turkey, turn even more negative.  In the short-term, Turkey has soft spots, which can cause the volatility coming from global markets, carry growth rate to a lower plateau; but long-term growth potential will still be determined by policy choices around fundamental strengths and weaknesses.  There are acute areas, which have potential to increase growth rate higher.  This article names four of them, mainly middle-class productivity, political inclusivity, Peace Process, and female labor participation rate.  Policies directly aimed at using ample potential in economy will help to keep Turkey’s investment case intact.