Risks Mounting In Turkey

Turkey faces only two challenges: politics and economics. These are conspiring to increase the downside risks of the Turkish lira. The news today is that the EC has put off until next month the decision to break off membership negotiations with Turkey There are two main areas of concern. The first is Turkey's refusal to open its ports to Cypriot ships. The second is Turkey's respect for human and minority rights. These issues can be addressed, if there is the political will. Prime Minister Erdogan indicated that he would be willing to consider amendments to Article 301 of the penal code that places curbs on freedom of speech.

There is also plenty of room for compromise on the Cyprus dispute. Turkey says it is willing to recognize Cyprus, a member of the EU, and end the commercial embargo IF the EU ends its embargo against Turkey's northern enclave in Cyprus. The fact that Cyprus is still unresolved itself demonstrates the diplomatic failure of both Turkey and the EU, especially after Greek-speaking southern Cyprus rejected the UN-backed unification plan two years ago. Back in February the EU approved a 139 million euro aid package for northern Cyprus of which none had been distributed until 38 million euros was delivered two weeks ago, shortly before the EU called off talks last week.

Finland holds the rotating EU presidency and in H1 2007 it passes to Germany. The political elite of both countries seem among the more sympathetic to Turkey's bid to join the EU. As one might expect, Cyprus, Greece and France appear to be the most hostile to Turkey's candidacy.

However, just as we argued in our recent quarterly that central and Eastern Europe appear to be suffering from reform fatigue, for its part EU suffers from enlargement fatigue. And this fatigue is all the more important given that the constitution that was to reform the decision making process as the community has grown, was rejected—though enlargement has continued with Romania and Bulgaria to join next month. Polls suggest that a majority of Europeans are opposed to Turkey joining their club. Meanwhile, enthusiasm for joining the EU has also softened in Turkey and now a majority is less inclined.

Macro-economic conditions are a cause of concern for many investors. One of the major issues is Turkey's large current account deficit. Yesterday the Sept shortfall was reported and at $1.92 bln was almost 50% larger than the consensus expected and the August series was revised to show an even larger deficit. That said, there has been a clear trend toward improvement since $4 bln blow out in April.

Concern about Turkey's current account deficit should also be mitigated by how it is being financed. The Institute for International Finance (IIF) estimated that Turkey may draw some $22 billion in direct investment this year. Particularly in play have been Turkish banks. US, German, Belgian, French, and Italian banks have made forays. Also their has been foreign interest in the assets being privatized by the government. However, it is not clear that Turkey should count on such direct investment flows next year, leaving hot and more fickle money to finance the deficit.

Hot money--attracted to Turkeys high yields and equity market valuations may continue. Several investment houses have increased their recommended weighting of Turkish stocks. The average p/e ratio is about 12-times estimated earnings, compared with 14 for the MSCI EM index. The main stock market index loss nearly 50% in the May-June period and has subsequently recovered about half of it back.

Inflation is another macro-economic challenge. Inflation has fallen from the 73% recorded at the start of 2002, but progress this year has been painfully slow. For the last few months, Turkey's year-over-year pace has held above 10%, compared to a little below 8% at the start of 2006. Turkey's inflation was bolstered by the lira’s 23% fall in the May-June swoon. Since June 7th, the central bank has hiked rates 425 bp to 17.5%. These higher rates, coupled with the pause in the Federal Reserve’s tightening cycle and a decline oil prices have seen the lira recover most of its spring decline.

Since August, the lira has been quite steady, with the dollar trading in a TRY1.4350-TRY1.5500 range, and even that probably exaggerates the real trading range. At this juncture, it is difficult to see how Turkey will get inflation down to the 4% level next year that the IMF's $10 bln accord calls for. A number of technical indicators warn of the risk of additional TRY losses in the period ahead. For the moment the dollar is held in check by a 7-week downtrend line that comes in just below TRY1.47. A convincing break of this area could signal a new assault on the TRY1.55 area. The dollar's downside momentum faded in the TRY1.43 area and this denotes support. Lastly, note the central bank has indicated it may resume auctions to buy dollars as it has to boost its reserves to prepare for next year's debt payments.
Risks Mounting In Turkey Risks Mounting In Turkey Reviewed by magonomics on November 08, 2006 Rating: 5
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