Is Turkey Headed for Financial Crisis, Again?

Historically, Turkish stocks have been a lot more volatile than other emerging market stocks. Although Turkish stocks have had a very good run after the financial crisis experienced by the country during 2001-2002 period, the Turkish GDP growth and stock market performance numbers were measured from a very low base registered during the crisis. 2006 was generally a very good year for emerging markets, but Turkish stocks did not participate in this broad-based rally.

There is a severe lack of understanding by international investors of the dynamics that shape the Turkish economy its financial landscape. The first thing to know about the Turkish stock market and the currency (Lira) is that they move in tandem with developed markets. For example, increased confidence in the U.S. means increased confidence in Turkish markets, or vice versa, no matter what is happening fundamentally in the Turkish economy, at least in the short run.

International liquidity flows are the most important determinant factors in the pricing the Turkish markets and currency, thus the domestic markets follow rise-and-fall movements dependent on the liquidity-in, liquidity-out policies of macro funds. The market is a lot more reminiscent of the day-trading of U.S. stocks, for five minutes to an hour, which usually follow the buy or sell decisions of the “big guys” (mutual funds, hedge funds). But for U.S. stocks at least, we can be sure that fundamentals will prevail in the longer run, thus we can make decisions based on those fundamentals as we see fit.

So what are the “fundamentals” of the Turkish economy, and will they prevail despite the dominance of international liquidity flows? Besides the “external anchors” of IMF and talk of the European Union (will we ever see that?), along with the much talked about election year (2007), what are some of the real risks faced by Turkey? International investors are vaguely familiar with the record current account and trade deficits experienced by Turkey, but since this problem is too reminiscent of the twin deficits of the U.S., they don’t really take it that seriously. Should we be concerned? Absolutely!

Trade deficit experienced by Turkey is of a much more serious nature than that experienced by the U.S., since Turkey has a much shallower capital market pool and greater dependency on global flows. On top of that, Turkey offers around 11-14% interest in real terms to keep the global funds interested. Remember the much talked-about carry trade financed by the Japanese yen to take advantage of higher real yields in other currencies? Real returns don’t get much higher than the ones offered by the Turkish Treasury today. In fact, these returns have caused the appreciation of Turkish Lira by some 40-50% in real terms since 2001-2002, because the world wants to take advantage of them. The currency overvaluation explains the record trade deficits, while high real interest rates ensure the capital flow necessary to finance them.

These flows could reverse themselves, when international or domestic arbiters decide that they don’t want to take the higher risks related to the macro picture. In fact, global emerging markets abound with similar crisis stories, but the Turkish crises of 1994 and 2001 have also witnessed similar outflow of funds.

But perhaps the most important thing associated with such currency overvaluation is the illusion of GDP growth. When measured in real terms (adjusted for inflation), the growth numbers from albeit low bases of 2001-2002 are not that impressive. Unfortunately, the Central Bank has decided that currency stability is the best way to ensure economic stability, which means keeping the currency at its present overvalued level, even if it means defending it by further raising interest rates. Needless to say, the overvalued currency has stifled domestic production and suppressed manufacturing capacity vis-à-vis international competitors. High real interest rates have crowded out private investment of individual firms, as well lowering the valuation their stocks. How could the stock market thrive for the longer term, given the business and entrepreneurial environment that seems so hostile for Turkish companies?

While we could see some rosy forecasts and more capital inflow into the Turkish markets, the longer view will not be similar to other emerging markets who are on a stable trajectory of real growth accompanied by actual job creation. The only way for the Turkish markets to get back on track is through a radical currency correction along with a decline in real interest rates. If accompanied by a severe outflow of funds and mismanaged by the monetary authorities, this necessary correction could unfold as a financial crisis.

TKF 1-yr chart