Friday, 14 January 2011

So Far So Good, But Can It Continue?

The Turkish economy has put up some glittering numbers in the past few years. GDP growth has averaged 4.5% from 2002 – 2009 and is expected to exceed 6% in 2010. Per capita income has risen to about $10,000. The US Dollar index of the Istanbul Stock Exchange rose a healthy 20% in 2010. Foreign trade is booming. The banks avoided the toxic asset crisis that hit so much of the United States and Europe and now enjoy healthy capital adequacy ratios. On Jan. 14 spreads on Turkish 5-year Credit Default Swaps were only 143 basis points compared with 1,005 bp for Venezuela, 965 bp for Greece or 541 bp for Argentina. All in all an enviable performance.

But, behind all that a glitter there are major structural weaknesses that could slow down or even de-rail this strong performance. Turkey has been one of the main beneficiaries of a benign environment for emerging markets, and the rush of volatile money into the country over the past few years has literally papered over the weaknesses. Fund managers desperate for decent returns have fled the near-zero interest rate environment of the American and European markets for higher interest rates available in emerging markets like Turkey.

The major crack in the structure is Turkey’s gaping current account deficit, basically the country imports far more than it exports. Exports have shown impressive growth from $36 billion in 2002 to an estimated $112 billion in March 2010. Unfortunately, import growth has been even more impressive from $51 billion to $180 billion in the same time. The size of the gap by itself is worrying, but manageable. The real problem is that this deficit has become a permanent and growing feature of the Turkish economy while the methods of financing it are deteriorating. Essentially, Turkey depends upon short term, very volatile inflows to finance this long term and growing deficit.

The problem is not just that Turkish citizens have suddenly developed a taste for fancy European cars, Cuban cigars, or Hermès scarves. They have, but consumer items are still a small percentage of total imports. The deeper and more serious nature of the Turkish current deficit is exhaustively covered in a paper prepared by the staff of the Central Bank in March 2010. Unfortunately this paper is available only in Turkish, and it did not get the exposure it deserves.

The main conclusion of the paper is that since the 1980s the structure of the Turkish economy has changed rapidly from one based on agriculture, textiles, leather goods, and a few raw materials to one where foreign trade and manufacturing play a much larger role. Today the growth engines of the Turkish economy are major industries like automotive, home appliances, televisions, steel, and processed foods. And each of these relies heavily on imported raw materials and equipment.

Another major problem for Turkey is that it imports just about all the oil and natural gas it uses. That bill alone amounted to about $30 billion in 2009. It only gets worse as the economy grows and uses more oil and gas. Turkey has also benefitted from relatively depressed gas prices and moderate oil prices of the past few years. This situation could change for the worse at any minute as energy demand increases sharply with improving economies in Europe and the United States and prices begin to escalate.

Even excluding oil and gas imports, the authors of the Central Bank study did a survey of major Turkish companies that revealed imported raw materials and equipment averaged 67% of total manufacturing expenses in 2007. Sample import percentages were 87% in petroleum/chemicals, 83% in electronics, 65% in electric equipment, 58% in transport, and only 25% in furniture. Turkey does have large forests to provide plenty of wood for furniture.

According to the study, it is precisely those sectors with heavy import content that have fuelled the sharp increase in Turkish exports. Since 1996, for example, the share of textiles and clothing in Turkish exports has fallen from about 15% to less than 8% in 2008. The share of agricultural product exports fell from just under 10% to about 3% in the same time. Meanwhile the share of automotive exports has risen from 4% to 14%. Exports of other major industries that were small or non-existent in the 1980s, i.e. home appliances and televisions, have also surged in the last 10 years. These industries also have high import content.

One of the factors aggravating this situation, according to the report, is that the supply chain in Turkey is underdeveloped. Manufacturers are forced to look outside for inputs. A couple of examples highlight this dilemma. A friend of mine brought a group of colleagues from Silicon Valley to Istanbul to establish a company producing high quality internet and VOIP products. All the engineering work is done in Istanbul, but he has to have the manufacturing done in Taiwan. Turkey simply does not have companies capable of supplying the required high quality work. Another friend has a company producing very good cotton shirt fabric for export mainly to Europe. Despite the fact that the company is located less than five miles from one of Turkey’s largest cotton fields he imports every gram of cotton from the United States and Egypt. He said domestic cotton is more expensive and much lower quality. Even the best weaving machines have to be imported.

The government is trying to address these problems by working to improve the technological component of domestic companies as well as encouraging home grown technology companies. This is admirable, but the results will not show for a very long time long time. And time is a luxury Turkey does not have.

Turkey has to continue on a high growth path to address its serious unemployment issue. The official unemployment rate in 2009 was 14%, and was even higher in the urban areas. The relatively young and growing population is only going to put more pressure on these employment statistics. The conundrum is that the faster it grows the larger the deficit becomes.

Further complicating the issue are the national elections scheduled in about six months. It is unreasonable to expect any government to exercise restraint in the pre-election period. Deputy Prime Minister and Economy Minister Ali Babacan and his colleagues in the Treasury have done a very good job up to now controlling the economy and managing the country’s debt. Their skills will be sorely tested in the next few months.

Again, the problem is not so much the size of the current account deficit itself as the deteriorating means of financing it. Ideally one would match the long-term built-in nature of the current account deficit with long term funding that comes with foreign direct investing. This number, unfortunately, is dropping sharply in Turkey. For years it was an insignificant amount, and then took off in 2005 when it reached $10 billion. The peak was 2007 when FDI amounted to $22 billion. By 2009 it had fallen to $8.4 billion, and will be even less in 2010. The result of this decline is that Turkey has to rely even more heavily on debt and portfolio flows to cover the gap. The conditions for the past few years have been ideal for doing for doing just this. Even though Turkey has not yet been given an Investment Grade rating by the rating agencies, its superior debt management has resulted in moderate interest rates for its debt. In addition, the herd of portfolio managers seeking higher returns has been flocking to emerging markets.

So far so good, but this beneficial environment can change overnight with moves by central banks in the United States and Europe to end quantitative easing programs and tighten their monetary programs. Sooner or later this will happen. But only the very brave, or foolish, are willing to predict exactly when. However, as we have seen so many times in the past, when this happens there will be a stampede into the ‘new’ opportunities leaving countries like Turkey somewhat in the lurch. Turkish officials have done a good job managing the economy through the global crisis, but the real challenge could lie in the future when global investment trends that are completely out of their control change suddenly leaving a very large hole in their accounts.

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