Anupam Damani, Managing Director, Emerging Markets Fixed Income, TIAA-CREF
Aaron Enriquez, Analyst, Emerging Markets Fixed Income, TIAA-CREF
August 13, 2013
Emerging markets have benefited from robust capital inflows of nearly $4.5 trillion1 over the last five years as global investors searched for yield in response to the extraordinarily low interest rates and economic stimulus policies that the United States and other developed markets adopted after the recent financial crises. Turkey was no exception to this trend, as it became one of the emerging-market “stars” outside of the oft-discussed BRICS countries (Brazil, Russia, India, China and South Africa) due to its a modernized, fast-growing economy and political and economic stability fortified by the ruling Justice and Development Party (“AKP”).
Emerging markets have since hit a stumbling block as the flow of easy money, which led to lax policymaking and rapid credit growth in several of these countries, is now beginning to reverse. In Turkey, addressing the well-publicized external imbalances (the difference between imports and exports) has been further complicated by increasing government interference in the macro economy and civil society. The country, already wrestling with persistently wide current account deficits and high inflation, is now beginning to face the challenge of a slowing economy, declining currency (lira), rising unemployment, and civil unrest. Meanwhile, the AKP has begun to take a more hardline stance both in its rhetoric and actions.
Turkey’s appeal is grounded in its advanced, diverse, and geographically strategic economy coupled with a decade of political stability, thus making it a standout in the region for both global investors and geopolitical observers. World Economic Forum currently ranks the economy 43rd out of 144 countries in its 2012-2013 Global Competitiveness Index, up 18 spots in the past two years alone.
Dating back to the end of World War II, Turkish politics had been plagued with coups and instability, which contributed to persistently high inflation and massive debt build up. This trend ended in 2002 with the election of Prime Minister Recep Tayyip Erdoğan and his party, the AKP. The AKP’s ability to maintain and consolidate political capital through three consecutive elections along with working with the European Union and International Monetary Fund provided a positive anchor for the economy and investor inflows. Since then, gross domestic product (GDP) has tripled, per-capita GDP has risen by 43%, and exports have expanded tenfold. As financial crises hit and other emerging markets slowed, Turkey has demonstrated resiliency and an ability to adapt. For example, Turkey managed to avoid the worst effects of the developed markets financial crises by re-directing its trade relationships to the Middle East (Iraq recently surpassed Germany as Turkey’s largest trading partner). And while economic growth has slowed to 4% from over 8% prior to the financial crisis, the Turkish government has been able to keep budget deficits within 2.5% of GDP, thus maintaining public debt at 37% of
GDP2 – levels significantly lower than most European countries. The country’s ability to maintain a relatively strong balance sheet while advancing economic development and political clout in the past five years was rewarded in the form of continuous foreign investor flows (which helped offset the country’s traditionally weak international trade position) and investment-grade ratings assigned by Fitch and Moody’s in the past year.
However, this robust economic performance has come under strain due to a changing external environment, including a gradually improving U.S. economy, signaling the potential end to abundant liquidity and resultant cheap foreign investor inflows into emerging markets. Meanwhile, problems have also begun to bubble to the surface domestically as Turkish society has become increasingly frustrated and polarized over what some view as the AKP’s patronizing and encroaching rulings on individual rights and freedoms (e.g., increasing media censorship, limits on the sale/consumption of alcohol, limited local consultation on urban development). Prime Minister Erdoğan’s increasingly conservative, Islamist political agenda has made many Turks, who had been accustomed to a modern, secular society, uncomfortable. In late May, these frustrations evolved into full-blown protests across the country following the government’s forceful police crackdown on the Taksim Gezi Park protests and subsequent rallies and sit-ins. The government’s ongoing hardline rhetoric and actions against the protests, lack of visible dissent within the AKP, and diminishing checks and balances within the government (particularly in the executive branch) serve as a wakeup call to observers (and investors) that Turkey’s transition to a mature democracy still has far to go. This fact also resonates in the macro economy, where the Erdoğan administration’s preference for low interest rates (as it prioritizes growth) politicizes the central bank’s monetary policy despite the institution’s operational independence. This approach entails many risks, particularly due to the country’s sizeable and recurring current account deficits (signifying a lack of competitiveness, thus weakening the value of the currency) and sticky inflation (both of which are averaging 8% in the past five years). For the past half-decade, foreign inflows have offset the external imbalances, but the nature of these flows has evolved from “sticky,” stable foreign direct investment (FDI) flows into more speculative, volatile portfolio inflows. Thus, when emerging markets began losing their appeal relative to the U.S. and Europe in the first half of 2013, the lira was impacted more severely than other EM currencies. This has placed the central bank between a rock and a hard place, forcing it to balance the government’s pressure to keep domestic interest rates low while trying to address the added market pressure on the lira.
Lately, investors have become skeptical about Turkey’s ability to tackle all of these issues effectively. Sovereign credit default swaps (CDS), which investors can purchase as protection against a bond default, are one barometer of investor confidence in the soundness and sustainability of government debt. The 88% increase in CDS rates on Turkish government debt since May (see Figure 1) is one indication that investors believe risk is rising. Another such barometer is the value of a nation’s currency. The value of the Turkish lira has declined by over 10% versus the U.S. dollar between February and mid-July 2013, signaling declining investor appetite for Turkish assets (also see Figure 1). In response, Turkey’s central bank (CBT) has already used up 10% of its net foreign-exchange reserves (typically seen as a cushion for non-reserve currencies) in an attempt to support the lira. This action renders the currency more vulnerable and could have been avoided had the government not pressured the CBT to keep interest rates low. In late July, as a result of additional market pressure on the lira, the CBT finally raised its overnight interest rate by 75 basis points; however, the hike was not sufficient enough to see any meaningful reversal of outflows.
Figure 1: Turkey’s currency has depreciated, while its government debt has become riskier
Turkey has, in the Erdoğan era, experienced remarkable economic expansion, a rising diplomatic profile and ascension to emerging-market star status among international investors. If the country successfully navigates an economic slowdown and is able to show that it can become a more inclusive democracy, international investors should continue to look at the country favorably for the medium to long term, despite the near-term turbulence.
The challenge for the country today is to accommodate a rise in developed-market interest rates, a global slowdown in emerging-market growth, and reduced investor inflows—all while keeping international investors and domestic political factions prosperous and content. Economic and political fallout from the recent protests is likely to be limited in the near term due to fractured and weak opposition, though the ruling AK party will likely lose some support. Tensions remain high given the busy upcoming electoral calendar (local and Presidential elections in 2014, Parliamentary elections in 2015). The party is still likely to win Turkish elections in 2015, though the loss of its popularity from recent events could mean that a coalition government takes shape, rather than the one-party domination the AKP has enjoyed over the past decade. There is great long-term potential for the economy, but unless the government enacts some much-needed structural reforms, growth will likely average only around 4.5%, rather than the potential 7%-8% that might be achievable.
1Institute of International Finance, “Capital Flows to Emerging Market Economies,” January 2013.
2Ilan Berman, “Turkey’s Kurdish Arithmetic,” Forbes, May 20, 2013.
The information provided herein is as of August 13, 2013.
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