ANALYSIS: Investor love affair with Turkey may end in tears
The recent war of words between German Chancellor Angela Merkel and Turkish President Recep Tayyip Erdogan shows there's no love lost between the two leaders.
The same cannot be said about investors who have become increasingly captivated by Turkish stocks over the past year. The vast sums of money flowing into the market are a sign of a solid economy, but there are growing concerns that things are becoming unbalanced, analysts say.
Capacity pressures, double-digit inflation and a burgeoning trade deficit may bring Turkey's economic trajectory down in tears.
The Borsa Istanbul 100 Index, which tracks the strength of Turkey's stock market, is up 44 percent over the past 12 months through Thursday, according to data from Bloomberg.
Part of the reason investors are flocking to Turkey is a broader attraction to emerging markets. They typically grow faster than the economically developed countries of Western Europe and the US. In short, there are more profits to be had in emerging markets.
Investments in Turkey are what finance experts call a "high-beta play" on emerging markets, said Francesc Balcells, an emerging markets portfolio manager at PIMCO in London. That means when emerging markets perform well as a whole Turkish investments should do even better.
"Turkey is always a massive beneficiary of that," said Balcells.
There are also some variables particular to Turkey that give investors an incentive to inject cash into the country.
The inflation-adjusted cost of borrowing money is close to zero and sometimes even lower than that. For instance, the overnight lending rate was 9.25 percent on Thursday, against inflation of near 11 percent. Such so-called low "real" interest rates allow investors to borrow greater sums of money and consumers to have more spending cash.
To spur the economy even more, the government introduced an ad hoc measure to stimulate lending further. Specifically, the government launched a programme to guarantee a portion of loans made to businesses. The initial promise was to back $73bn. This move is widely believed to be part of Erdogan's plan to boost the economy ahead of a 2019 election in hopes of keeping his position.
The result is a massive ramp-up in credit growth that is the "largest expansion of credit stock for a decade," said a recent report from TS Lombard, a company that deals in economic forecasting. The credit growth has also shown up in money-supply statistics. M3, a broad measure of nationwide money circulation, increased to about $457bn in July from $425bn in December last year, according to data from Trading Economics.
It gets better. The government has also become uncharacteristically spendthrift.
"On the fiscal side, traditionally Turkey has been pretty conservative," said Balcells. "But we have recently seen a slippage in fiscal discipline."
That has already got forecasters at Trading Economics eyeing increased fiscal deficits in the second half of this year.
All of which - the credit growth and the government spending - has led to what London-based TS Lombard describes as "high expectations" for second-quarter economic growth, seeing a possibility of 6 percent for the full year.
There are solid reasons to expect a strong reading on the economy. The manufacturing sector is doing exceptionally well. The recently released Markit Istanbul Manufacturing PMI report, which measures the strength of the factory sector, returned a reading of 54.2 in August – the country’s highest reading since January 2014. A reading above 50 shows expansion in the industrial economy, while below 50 means contraction. The Markit report references "strong expansions in output and new orders".
The economic engine is overheating
However, despite robust growth projections, there are worries that the economy is now overheating and may be unable to sustain growth.
"Signs of capacity pressures were evident as suppliers' delivery times lengthened, backlogs rose, and input price inflation accelerated," the Markit report said. In other words, the economy is so hot that companies can't keep up with the credit-fuelled boom in demand, leading to delays in getting products to the customers.
Inflation has run at double digits for most of this year, according to data from Trading Economics, with the reading for August at close to 11 percent. Notably, year-on-year transportation costs rose more than 17 percent, which is something that cuts straight into the wallets of Turkey's working population, just like a tax increase. It is the same idea that when gasoline prices jump US consumers get hurt.
Another sign of overheating is an unsustainable appetite for imports.
"Turkey's trade deficit increased markedly by 82.5 percent to USD 8.8 billion in July 2017 from a USD 4.8 billion shortfall in the same month a year ago," according to Trading Economics.
"It is the biggest trade gap since December of 2013, as imports jumped 46.2 percent." The trade gap is the difference between the value of exports sold and the value of imports.
As most people know, all parties must eventually end, and the bigger the festivities the more severe the hangover. Turkey will likely be no exception.
There are already signs indicating that this level of economic growth cannot continue.
Now that the loan-guarantee programme is basically finished, there won't be as much of a loan-fuelled boost to the economy, so investors should expect any economic momentum from that programme to peter out within a few months.
"Now that this facility is coming to an end we are seeing a sharp reduction in credit growth," said PIMCO's Balcells, referring to Turkey’s loan guarantees.
That will surely put the brakes on the economy, perhaps as soon as early 2018.
"The effect of a post-stimulus hangover may be more severe on the supply side,” said a recent report from TS Lombard. "The single most important part of the stimulus package was the expansion of the government’s credit guarantee programme."
In other words, a key part of recent stellar growth in the economy was the loan-guarantee programme that helped businesses expand their firms.
What will happen without it? A nasty (credit) hangover, perhaps. That's when firms pull back on spending as they try to pay down their debts.
There may be another problem. Expect inflation "to become stickier from now on," the Lombard report said.
Put another way; Turkey faces inflation that may stick around even as the Turkish economy slows and as Erdogan approaches the election.
That is, unless Erdogan and his minions can pull an economic rabbit out of the hat.
Failure to do so may have a harsh impact on Turkey's economy.
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