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Economic Research Athens, July 4, 2006 Trip Notes: Turkey Key notes from our recent trip to Ankara and Istanbul: June 26-28 Outlook During the past week we traveled to Ankara and Istanbul Ratings Short Term: negative/neutral Medium term: neutral/positive Long Term: neutral/positive S&P: BBMoody’s: Ba3 Fitch: BB- where we met with officials from the Central Bank, the Ministry of Finance and the Privatization Administration as well as market participants to discuss recent developments in politics and the economy and prospects going forward. Key points: Economy now in a better shape to cope with external shocks than during past incidents of turmoil CBRT’s latest tightening measures temporarily Disinflation halted but medium-term wave of risk aversion and global de-leveraging began to unfold in early May. Overstretched valuations, a to the disinflation process and, more recently, increased domestic political noise provided some of the key catalysts of this underperformance. In the current Economic slowdown but not recession ahead whole emerging markets universe since the latest large and widening current account deficit, headwinds structural forces remain in favour sell-off, likely to lag in a recovery Turkey has been one of the worst performers in the successful in stabilizing lira, at least Turkey underperformed other EMs in the recent environment of increased aversion to risk, investor selectivity and discrimination against markets featuring weak fundamentals will remain of primary importance for at least until global conditions stabilize. Turkey’s Structural reforms on a fast track short-term fundamentals have worsened as a result of the crisis, thus we expect Turkish markets to remain vulnerable in the short-term and to lag other major Turkey: Macroindicators GDP growth % CPI eop (yoy %) Budget balance (% GDP) C/A balance (% GDP) Total external debt (% GDP) EMs in any broad-based recovery. On a medium-to2004 8.9 9.3 -7.1 -5.2 50.0 2005 7.4 7.7 -2.0 -6.4 45.0 2006 figures represent official forecasts as well as our own projections 2006 5.0 8.5 -1.5 -6.2 43.0 longer term perspective, we remain positive on the country’s outlook, given the significant progress that was made in recent years in stabilizing the economy and in pursuing a series of structural reforms that have mended its past boost and burst tendencies. We also expect the ongoing IMF deal to continue reducing the scope for significant deviation from tight fiscal policy and to ensure continued efforts towards economic stabilization. Analysts: Gikas Hardouvelis, Chief Economist and Director of Research Platon Monokroussos Head of Financial Markets Research Strong growth in recent years, financed mainly by short-term foreign capital Over the past three years, Turkey enjoyed a virtuous cycle of currency strength, easing inflation and falling interest rates, which, in turn, boosted domestic credit and fuelled a strong economic expansion. Average real Important disclaimer at the end of this report Economic Research GDP growth exceeded 7.0%, remaining among the foreign speculative capital rushed to exit the market highest in the emerging world and almost twice as ‘‘at any cost’’ amid escalating global aversion to risk. high as last decade’s average. This strong growth The central bank’s initial lack of decisive action (in the performance was not well balanced, however, as it form was mainly financed by short-term credits and intervention), portfolio inflows (the C/A deficit reaching 6.5% of government’s GDP), making it crucially susceptible to sudden policy affairs, were interpreted by markets as a failure reversals to in investor sentiment and foreigners’ willingness to provide financing. of further display rate together earlier firm hikes with and/or memories interferences commitment direct to with the of FX the monetary disinflation program. Indeed, the subsequent sharp depreciation of the lira exacerbated the market worries that the CBRT The combination of relatively high domestic interest was left ‘‘behind the curve’’ in its fight against rates and a broadly strong home currency offered inflation2. one of the highest returns on short-term speculative capital in the emerging world, causing significant CBRT’s latest tightening measures successful in capital inflows and an increase of CBRT’s foreign stabilizing lira, at least temporarily currency reserves, which almost doubled over the In an extraordinary MPC meeting held on Sunday, June past two years to approximately $58bn currently. 25, the CBRT hiked its key overnight borrowing rate by FDI inflows, though increasing strongly in recent 225bp to 17.25%. It also announced its decision to quarters1, have been providing a relatively small initiate daily dollar selling auctions of a maximum cover to the current account deficit, with most of the volume of $500mn as well as lira purchase ‘‘depo’’ financing being achieved via foreign loans, inflows to auctions of 1-wk and 2-wk maturities aiming to drain the local bond and equity markets and reverse excess liquidity from the market. Then, on June 28, currency substitution by domestic residents. On this the CBRT raised its key overnight lending rate by a latter point, note that the net errors and omissions further 200bp to 22.25%, while it left its overnight item in the BoP statistics, which reflects unregistered borrowing rate unchanged at 17.25%. The CB has so capital flows such as shifts of informal foreign far hiked its overnight borrowing and lending rates by currency savings back to local currency deposits, 600bp and 400bp, respectively since the beginning of reached particularly high levels in the past three June. years, though the recent lira decline must have led to a temporary halt to this process. The latest tightening steps, together with active FX intervention by CBRT, have succeeded to stabilize the Risk aversion, CBRT’s lack of decisive action lira, albeit at much weaker levels than before the behind lira’s recent depreciation recent sell-off, and to restore the Bank’s inflation The awkward reality of Turkey’s increased fighting credibility, at least temporarily. Higher dependency on foreign short-term capital inflows domestic interest rates are expected to help contain manifested itself via the recent dramatic plunge in inflationary pressures by constraining private sector the lira, which reached a climax shortly after the credit and contributing to a cooling down in domestic CBRT’s unchanged-rates decision on June 20. An demand growth over the coming quarters. Moreover, earlier surprise 175bp hike in the central bank’s the CBRT’s recent overnight borrowing rate and the abolition of a attractiveness of lira-shorting strategies, while the withholding tax on non-resident holding of local current daily dollar selling/lira depo auctions are rate hikes have reduced the bonds had little success in stabilizing the market, as Net FDI receipts reached $9.7bn in 2005 and, including cash from deals cut last year, are expected to reach between $13.5bn and $24.3bn in 2006, depending on how much cash Saudi Oger Telecom pays for Turk Telecom ahead of schedule. Turk Telecom was privatized last year in a $6.55bn deal. 1 The Turkish currency hit 3 ½ yr lows above 1.77 to the dollar on June 20th but it has recovered significant ground since then, helped by the CBRT’s latest package of tightening measures to halt its rapid decline. 2 Trip Notes: Turkey, June 27, 2017, Page 2 of 6 Economic Research facilitating the mopping up of excess liquidity, which currency to inflation of ca 0.30ppts (affecting the CPI’s has been a key factor behind the recent lira volatility. tradables component), with the maximum impulse- Since the CBRT initiated its new daily sterilization response being felt within a three-month horizon. operations on June 26, some TRY 5.4bn of excess lira Lastly, note that under its inflation-targeting regime liquidity were absorbed from the market, while a the CB had forecast that inflation would end June further 3bn liras were also withdrawn on account of within two percentage points of 6.5%, before easing tax payments by corporates. This reduction of TRY towards 5% by the end of the year. Now, with its liquidity overhang (which, according to one of our expected failure to meet those IMF-agreed targets, it is contacts, stood at more that TRY 15bn before the likely latest sterilizations) has certainly contributed to the inflationary pressures subside. to continue its tight policy stance until lira recovery over the last few sessions, while the broad-based US dollar weakening post the 29 June Supply FOMC also supported it. The TRY rate stood at ca pressures 1.55 again the US dollar at the time of writing, up by Our CBRT contacts attributed the recent upward move ca 13% from its lows beyond 1.76 on June 20 but in inflation to higher commodity prices, supply-side still 16% down from its late-April levels. With the disruptions CBRT appearing determined temporary price influences that pushed headline CPI upward in January-May without affecting much the underlying inflation rate. In fact, FX intervention were market volatility to increase, we the see the TRY maintaining its recent gains and even unprocessed food, gold and alcoholic beverages came strengthening the short-term its other demand-side new in apply and vs. measures more aggressively and even conduct direct further to constraints in CPI index excluding the volatile energy, the in at 5.5% y/y in May, in line with the central bank’s absence of any fresh major round of global risk year-end target. We generally give credence to the aversion. above line of reasoning but we believe that demand side pressures, especially in the prices of non- Upside inflation risks tradables, have also contributed to the upward move The lira’s depreciation since early May has certainly in inflation since the beginning of this year. An worsened Turkey’s near-term inflation outlook but important actually the country has begun experiencing rising constraints’’ argument is the sharp rise in the food inflation since early this year as a result of elevated components (accounting 27.7% of the CPI basket), commodity prices and demand-side pressures. After which posted a 6.5% cumulative rise in the first 5 decelerating from around 73% y/y at the beginning months of the year and came in at 10.4% y/y in May. of 2002 to 7.1% y/y in June 2004, consumer price This increase was mainly due to unprocessed food inflation has been stuck in a narrow range before prices (14.2% basket weight), which rose by an eye- moving higher again in the last several months. The catching 11.4% in January-May, reportedly as a result rise in the year-on-year CPI to 10.1% in June from of supply disruptions due to unusually bad whether 7.7% at the end of last year, though not necessarily conditions earlier this year. Another development signaling the end of the medium-term disinflation which trend, has prompted a gradual rise in inflation commodity prices on Turkish inflation is the sharp rise expectations, as depicted in the CBRT’s recent survey in the CPI basket’s miscellaneous component by ca data. According to CBRT’s estimates, the weak lira 11.5% in the first 5 months of this year, mainly as a has inflated the May CPI rate by 65bps and its impact result of higher prices of gold (1.4% basket weight). is likely to be particularly acute in the July and On the non-tradables side, rent prices remained a August CPI figures. Most of our contacts expect source of inflationary pressure since the beginning of headline CPI rate to move above 12% y/y in the next the year, leading to a rise of more than 11% in the CPI two months, while the CB expects no sustained basket’s housing component in May. However, tighter resumption of disinflation before Q2 2007. These financial conditions in the period ahead are likely to development also shows the supporting impact of the ‘‘supply- international projections assume a pass-through coefficient of Trip Notes: Turkey, June 27, 2017, Page 3 of 6 Economic Research calm somewhat the recent boom in the housing Increased political noise likely to persist market and lead to an ebbing of price pressures in Two sources of political noise are likely to keep this sector. markets unsettled in the immediate future. The first is the upcoming Presidential and Parliamentary elections. Disinflation halted but medium-term structural Presidential elections are scheduled for May 2007 and forces remain in favor national elections for October 2007. Higher commodity prices and the recent lira AKP holds an absolute majority Mr. Erdogan’s in the current devaluation are likely to lead to higher year-on-year parliament and can, therefore, easily nominate and CPI rates over the next 6-9 months, making the install its own presidential candidate, a prospect that 2007 inflation target of 4% +/-1% extremely difficult creates substantial uneasiness and discomfort among to attain. However, structural disinflation is likely to the opposition. If early elections were held today, the re-assert extraordinary AKP would likely risk to lose this majority and thus inflationary effects fade. Important dis-inflationary miss the opportunity to install its preferred candidate. impulses in the period ahead are likely to be Current polls indicate a small loss of support for AKP provided by a still negative output gap, continued relative to 2002, plus a high probability that three or strong more of the smaller political parties would manage to itself once productivity the gains recent and cooling domestic demand growth as a result of tighter monetary (as pass well as fiscal) conditions. Parliament. All this has given a strong incentive to the the 10% threshold required for entering opposition to keep raising the issue of early elections Fiscal policy to tighten further and for the government to try to keep the issue away Fiscal policy has been restrictive all along with from public discussion. primary surpluses in excess of 6.5% of GDP helping to reduce the public debt from around 100% of GDP The second major source of noise comes from the in 2001 to ca 70% of GDP at year-end 2005. The ongoing EU negotiations. The pro-EU mood (78% in present rise in inflation automatically implies an even favor) seems to have shifted substantially over the last more the year, bringing that percentage down to close to 60%. expenditure and the revenue side. Public expenditure The negotiations have created a feeling among the will decline in real terms because public sector public that the EU keeps shifting the “goalposts”. Up to nominal wages were recently set for a two-year a certain extent, the latter may reflect a lack of full period based on the CBRT’s target rates of inflation, understanding among the public of the seriousness of which were 5% for end-2006 and 4% for end-2007, the well below current market expectations for future consensus building within the European Union and, inflation. Moreover, in the ministerial meeting of particularly, the diversity of views among leading Friday, June 23, a decision was made to keep public European politicians and technocrats about Turkey’s expenditure at the previously set targets. While this accession prospects and sociopolitical behavior. In decision pre-election such an environment, something negative is bound to pressures next year, it nevertheless makes current hit the Turkish press and media almost daily, adding to discretionary expenditure policy more restrictive. the political noise and uncertainty. restrictive may policy not stance withstand both the on pre-conditions for accession, the culture of Budget revenues are also expected to increase, at least in the short-run, as rising inflation will likely Structural reforms on a fast track result in higher than previously expected direct and In line with the conditionalities of the recent IMF indirect tax revenues. programs, Turkey has moved very fast with the Of course, over a longer period of a year or so, budget revenues will also be implementation of structural reforms. affected negatively by a slowdown in economic system is now well capitalized, with regulatory capital activity, so the net result on the revenue side is likely at to be neutral. Problematic bank loans are now at just 5% of total 24.2% of risk-weighted assets Its banking at end-2005. loans, down from 40% in early 2002. Domestic banks’ Trip Notes: Turkey, June 27, 2017, Page 4 of 6 Economic Research balance sheets are well hedged against foreign depreciation of a similar magnitude in 1994 was also exchange risks and their interest rate duration gaps accompanied by a 5% slump in GDP growth. On a are low. State-owned companies are being privatized more positive note, the weakened currency helped at a very fast pace. According the Privatization eventually improve the country’s external position with Administration, $20bn of privatization funds were the current account balance switching from a deficit of secured in 2005 alone, while year-to-date receipts ca 5% of GDP to a surplus of 2.7% in 2001 and from - have already surpassed a TRY 8bn initial target for 4% of GDP to a surplus of 3% of GDP in 1994. With privatization revenues in 2006. More privatizations most forecasters previously predicting the economy to are in the pipeline: Three electricity distribution continue companies in the second half of 2006 and the average GDP growth in excess of 7% over the past remaining seventeen in 2007. Halkbank, the 6th three largest bank in Turkey is currently up for sale. Parts considerable pain on the economy and derail Turkey’s of the state tobacco company, Tekel, are also in line recent stabilization efforts. It could also hammer for privatization, 61% of Petchem, as well as three investor psychology further, coming as an acute seaports. the reminder privatization agency told us “The aim is economic behavior. As a high ranking official at performing years, of a strongly major Turkey’s in 2006, recession past following could boost-burst inflict growth efficiency, not just the extraction of funds for the purpose of reducing the national debt”. Meanwhile Slowdown but not recession ahead the reform of the social security system was recently As things stand at this point, and assuming no further passed into law and is about to go through the last significant deterioration in global investor sentiment Presidential hurdles before becoming effective. The towards risky assets, we believe that a protracted new law, among other things, aims to rationalize the economic recession in Turkey is unlikely. This view was retirement age, which previously gave an incentive endorsed by the CBRT, as well as our private sector for people to retire early and then seek employment contacts. The central bank now expects real GDP for another 10 to 20 years, often in the underground growth of ca 4.5% this year and 4.0% in 2007 but we economy, thus depriving the system of vital funding. believe that risks to the 2006 forecast are skewed to The IMF appears to be happy with the pace of the upside given strong growth in H1. Real gross reforms so far, and has suggested to the government domestic product expanded by a much stronger than that, from now on, it should pay particular attention expected rate of 6.4% in Q1 2006 despite weak to the efficiency of the tax system and the serious exports and adverse weather conditions and the problem of bureaucratic red tape. One official also economy has likely expanded at an even stronger rate pointed to us the need for a major overhaul of the in the second quarter on buoyant domestic demand. judicial system to make it more efficient and to improve the pace of resolution of cases. Economy now in a better position to cope with external shocks than during past turmoils Recent lira crisis likely to inflict pain in the Several recent developments make us confident that economy this time around the Turkish economy is in a better The recent mass exodus of foreign capital and the position to absorb the repercussions of a currency consequent sharp increase in domestic interest rates crisis than during past periods of major market to stabilize the lira and fight rising inflation will turmoil. First, the size of the recent lira correction (~ almost certainly lead to a slowdown in domestic 18% vs. the US dollar May-to-date) is considerably demand, as has also occurred in past major episodes smaller than in other past major adjustments, while of currency crises. In 2001, when Turkey was forced the most recent monetary policy tightening measures to devalue by ca 45%, the massive depreciation of appeared to have already stabilized the FX market and the lira and the ensuing sharp rise in interest rates reassured investors about the CBRT’s inflation-fighting pushed the economy into recession, with real GDP credentials. Second, the strong investment drive of contracting by around 7.5% during that year. A lira recent years has helped to expand the productive Trip Notes: Turkey, June 27, 2017, Page 5 of 6 Economic Research capacity of the economy, making it more resilient to Currently, around half of total private sector debt is external shocks. Third, the country’s fiscal position foreign currency-denominated with the bulk of the has improved considerably in recent years with the problem concentrated in the corporate sector, which government currently running a primary surplus in continues to run a sizeable short-FX position. Note also excess of 6.5% of GDP and an overall deficit of just that most of the existing loans to the private sector are 1% of GDP. Fourth, the public sector is in a much of variable rate, with the exception of consumer and better housing loans. The latter are fixed by law, have shape to cope with the recent market adjustments than in previous episodes preceding relatively currency years), and still represent a very small percentage of the total private sector loan exposure. All in all, the recent lira lengthening the average maturity of its debt over the depreciation may cause some servicing problems to last five years (total public debt-to-GDP ratio: 70% domestic corporates, with negative repercussions for now vs. ca 100% in early 2001; foreign debt as % of banks but the impact is not likely to be as severe as total debt: less than 30% vs. ca 40% in 2001). during the 2001 crisis, its debt implemented (3-5 significant in having maturities considerably reductions crises, low ratios and given the current much healthier state of the domestic banking system and the Finally, the current IMF stand-by agreement provides stronger state of the real economy. adequate external financing to the government, lessening the need to resort to external financing to cover its borrowing needs. In contrast to the public sector, the private sector currently appears more susceptible to default risks as a result of higher domestic rates and the recent lira depreciation and in view of the significant increase in its short-term foreign currency borrowing in recent years. Research Team: Platon Monokroussos, Head of Market Research Paraskevi Petropoulou, Roubiniana Drakopoulou Sales Team: Fokion Karavias, Treasurer Dimos Arhodidis, Danai Manoussaki Kostas Karanastasis, Nikos Laios, Alexandra Vogiatzi, Alexandros Trourinakis, Makis Savvidis. EFG Eurobank Ergasias, 8 Othonos Str. GR 105 57, Athens, Tel:(30210) 3718 906, 3718 999, Fax:(30210) 3337 190, Reuters Page: EMBA Internet Address: http://www.eurobank.gr Disclaimer: This report has been issued by EFG Eurobank – Ergasias S.A and may not be reproduced or publicized in any manner. The information contained and the opinions expressed herein are for informative purposes only and they do not constitute a solicitation to buy or sell any securities or effect any other investment. EFG Eurobank – Ergasias S.A., as well as its directors, officers and employees may perform for their own account, for clients or third party persons, investments concurrent or opposed to the opinions expressed in the report. This report is based on information obtained from sources believed to be reliable and all due diligence has been taken for its process. However, the data have not been verified by EFG Eurobank – Ergasias S.A. and no warranty expressed or implicit is made as to their accuracy, completeness, or timeliness. All opinions and estimates are valid as of the date of the report and remain subject to change without notice. Investment decisions must be made upon investor’s individual judgment and based on own information and evaluation of undertaken risk. The investments mentioned or suggested in the report may not be suitable for certain investors depending on their investment objectives and financial condition. The aforesaid brief statements do not describe comprehensively the risks and other significant aspects relating to an investment choice. EFG Eurobank – Ergasias S.A., as well as its directors, officers and employees accept no liability for any loss or damage, direct or indirect that may occur from the use of this report. Trip Notes: Turkey, June 27, 2017, Page 6 of 6