Friday, August 20, 2010

Financial Times: Turkey moves towards investment grade status

Istanbul’s ISE100 equity index has hit record highs. Yields on sovereign debt are close to historic lows. The currency is more stable than it has ever been – and strong enough to squeeze exporters. All this is the result of a new reputation for stability that Turkey has established in the past two years: its solid banking system, robust public finances and strong growth prospects led David Cameron, UK prime minister, to assert on a recent trip he paid to Ankara that “Turkey is Europe’s BRIC”.

Policymakers aim to bring inflation down from a forecast 7.5 per cent at the end of 2010 to a medium-term target of 5 per cent, and to keep interest rates in single digits for a prolonged period. Rating agencies have signalled that if a new fiscal rule is enacted and implemented, and if political uncertainties ease, the country could finally make the leap to investment grade.

“Turkey is emerging as a safer bet,” says Timothy Ash, an analyst at the Royal Bank of Scotland.

Ample liquidity and low borrowing costs have favoured an equity market heavily weighted towards financial stocks: Turkey’s MSCI index outperformed the MSCI emerging markets index by 10 per cent in 2009 and about 13 per cent in the first 7 months of 2010. Foreign investors own around two-thirds of stocks on Istanbul’s exchange.

By contrast, the bond rally that began more than a year ago was driven largely by local investors. Turkish banks were a captive market for government debt in a recession period when there was little appetite for corporate lending. Only in the past few months has foreign interest strengthened, with a net inflow of about $6bn-$7bn into lira-denominated sovereign debt since the start of the year.

US contract approval set to spur derivatives trade

TurkDex, Turkey’s derivatives exchange, yesterday said that it expected a boost in trading volumes after US regulators allowed its main futures contract to be made available to US traders and after Ankara exempted local banks and brokers from a 5 per cent tax on derivatives transactions, writes Jeremy Grant.

The Commodity Futures Trading Commission said it would allow ISE-30 stock index futures to be sold directly into the US. Previously US traders, except for a few hedge funds, were prohibited from trading Turkish derivatives.

The CFTC’s action follows similar decisions in recent years allowing the Brazilian, Mexican and Taiwanese futures exchanges to sell their key products directly to US-based traders.

Çetin Ali Dönmez, TurkDex chief executive, said exemption from a “banking and insurance transaction tax,” effective August 1, removed “a major impediment to liquidity of Turkdex futures contracts, currency futures in particular”.

Analysts say foreign investors’ relatively light positioning in the government bond market – just over 10 per cent, considerably less than in some eastern European countries – is a strength, making Turkey less vulnerable to a sudden sell-off.

Yet it also reflects a perception among investors that, with interest rates already at a historic low, there may be little scope in the short-term for bond prices to improve.

Real yields (taking inflation into account) are close to zero on lira-denominated debt and are therefore “not that attractive”, notes Tim Haaf, of Pimco Europe in Munich.

Kay Haigh, at Deutsche Bank, says “the risk premium on [lira-denominated] T-bills is very small these days ... it will be very difficult for the marginal investor to convince themselves they should be buying T-bills”.

“With yields where they are, negatives are not priced in. You can’t argue there’s a lot of bad news in the market,” adds another portfolio manager.

Most analysts think the risks this year are moderate but say Turkey’s reliance on foreign capital to finance growth – and its perennially turbulent politics – could become issues for investors early in 2011.

With a recovery driven by domestic demand, Turkey’s current account deficit is widening. Up to 2008, this was funded largely by foreign direct investment and companies’ external borrowing: now short-term portfolio inflows are more important.

“People wonder about the sustainability of financing,” says Christian Keller, an economist at Barclays Capital who recommends long bond positions at present.

By the start of 2011, investors will also be increasingly focused on elections, due to take place by next summer, which will be the first big test of the government’s commitment to fiscal discipline since it dispensed with International Monetary Fund oversight.

The ruling AK party’s ability to form a single-party government has been important to investment since it came to power in the aftermath of Turkey’s 2001 economic crisis. Now polls, although constantly shifting, suggest at least a possibility that the next government will be a coalition.

Given the prospect of a close vote, investors are also watching for signs of a pre-election spending spree that could complicate monetary policy – consistently dovish in recent months – just as the central bank governor’s term comes to an end.

“I am now a little more concerned about the fiscal outlook, the inflation outlook. The central bank still doesn’t have full inflation fighting credentials ... and the political headwinds are becoming more intense,” Mr Haaf says.

A decision to delay legislation enacting the fiscal rule raised eyebrows last month, as there is now no guarantee it will be in place for the pre-election budget.

The government should hit its fiscal targets this year with room to spare, but it appears unlikely to follow the IMF’s recommendation that it save all unbudgeted revenue to “help contain current account and inflation pressures, limit private sector crowding out, and reinforce the authorities’ fiscal discipline credentials”.

So far these worries are only small clouds on a predominantly sunny economic outlook. But as Mr Ash comments, “the big step will be to take Turkey to full investment grade – and this move will probably prove to be a more formidable hurdle.

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