Risk drivers and outlook

The lower global risk appetite for emerging market assets exposed Turkey’s Achilles’ heel: its large structural current account deficit financed by short-term capital flows and a low savings rate which contributes to boom-bust economic cycles. The recent political turmoil has exacerbated foreign investors’ risk aversion and has led to sharp capital outflows and Lira depreciation. The central bank reacted by sharply increasing the interest rate. Since then the Lira has recovered somewhat. Credendo Group has nevertheless downgraded its systemic commercial risk rating recently as funding costs are on the rise and 2014 growth prospect is meagre.

The sharp rise of ST debt in the past five years put pressure on short-term political risk, which represents the liquidity of the country. Nevertheless, the ST political risk so far remains moderate as it is mitigated by the healthy level of foreign exchange reserves which covered more than 4.5 months of imports in 2013.

The MLT political risk, which represents the country’s solvency, is somewhat impeded by the large current account  deficit, the low saving rate, large energy dependency as well as political uncertainty in the run-up to key elections and amid the fragile peace process with the Kurds. On the positive side, Turkey’s economic fundamentals are strong: exports are well diversified, public finances are solid and the external debt burden is moderate. The banking sector is well- regulated and capitalised although heavily reliant on short-term funding.

Facts & figures

Pros

  • Geographic location
  • Well-diversified exports
  • Solid public finance
  • Sound macroeconomic fundamentals

Cons

  • High reliance on short-term funding
  • Energy dependency
  • Low saving rate
  • Lingering Kurdish conflict

Main export products

  • Manufactured goods (49.3% of total current account receipts in 2012), tourism (12.1%), food (7.7%), gold (6.3%), transport (5.9%)

Income group

  • Upper middle income

Per capita Income

  • USD 10,830

Population

  • 74 M

Description of electoral system

  • Presidential: 7-year term, next election: August 2014
  • Legislative: 4-year term, next election: June 2015

Head of government

  • Prime Minister Recep Tayyip Erdogan

Head of State

  • President Abdullah Gül

Country risk assessment

Increased political uncertainty ahead of key elections

Recep Tayyip Erdogan has been Turkey’s Prime Minister since 2002 and secured his third sweeping victory in 2011. Erdogan, from the moderate Islamic Justice and Development Party (AKP), is credited for bringing Turkey unprecedented political stability and economic expansion. Together with his former ally Mr Gülen, he succeeded in reducing the power of the army, a key defender of a secular regime. Indeed, many military officers along with lawyers, politicians and journalists were convicted in trials (Sledgehammer and Ergenekon in 2012 and 2013) related to separate alleged plots.

The calm political scene was hit mid-2013 by mass protests brutally repressed by the police and end-2013 by large-scale corruption scandals involving businessmen and other key figures connected with the government - four ministers subsequently resigned. Recent events highlight the PM’s increasing authoritarian tendencies, the middle class’ concern about the country’s islamisation and split between Erdogan and former ally Gülen. The Gülen movement, a Turkish nationalist religious organisation which promotes a moderate Islam and dialogue between religions, has supporters throughout the society. Its members are believed to hold influential positions in institutions such as police, judiciary and prosecution service. Following the corruption probe, Erdogan has  adopted various measures such as dismissing police officers, introducing bans on Twitter and YouTube and closing Gülenist schools - aimed, among others, at curbing the Gülen movement’s influence in Turkey. This could lead to a rift within the AKP, the release of convicted military officers (some of whom have already been released) and the weakening of the independence of the judiciary and the press.

Political uncertainty has therefore increased ahead of presidential and parliamentary elections scheduled for August 2014 and June 2015 respectively. Parliamentary elections could even be advanced to 2014. The AKP has performed rather well during the March local elections, winning around 45% of the votes. After all, Mr Erdogan’s party has a strong support base among the rural and urban poor that hold conservative religious views. Besides, the AKP is credited for improving living standards of the working and lower middle classes. This bodes well for a victory of the AKP at the upcoming presidential elections.

It is not yet clear whether Mr Erdogan - currently barred by his party rules from running for a fourth term as Prime minister - will be a candidate in the August presidential election or actually run for a fourth term as Prime Minister. Until now, his attempt to change the constitution to transfer executive power from the Prime Ministry to the Presidency has failed as the AKP lacks the needed majority and has therefore to reach a compromise with the opposition parties. However, the opposition such as the Nationalist Movement Party (MHP) and secularist Republican People's Party (CHP) has so far refused to change the constitution out of fear that the authoritarian tendencies of Mr Erdogan will increase. His failure in attempting to change the constitution could explain Mr Erdogan’s recent announcement that the AKP’s three-term limit could be lifted.

Kurdish insurgency likely to resume amid fragile peace process

The lingering Kurdish question remains a threat to domestic stability. The armed conflict started back in 1984 and has its roots in the demand for autonomy by the Kurdish minority. Tens of thousands on both sides have been killed over the past decades. Mid-2013, the Kurdish Workers’ party (PKK) chief Abdullah Ocalan announced a ceasefire and the withdrawal of its fighters from Turkey. However, the peace process is fragile as the government has failed to make enough political concessions to the Kurds under the so-called 'democratisation package'. This package includes lowering the 10% electoral threshold which currently prevents smaller parties (including the Kurdish) from being represented in parliament, lifting the ban on headscarves for civil servants, new Kurdish  rights allowing for instance education to be provided in Kurdish in private schools, municipalities to take their native-language names, and the establishment of an anti-discrimination commission. However, the announced political reforms package fell short of meeting the Kurds’ expectations. As a result, Kurdish fighters have suspended their withdrawal and could resume the insurgency.

Despite unsettled disputes with Armenia and Cyprus, external relations are broadly stable. A Turkish military intervention in Syria (without multilateral approval) is highly unlikely but spill-over from the conflict cannot be ruled out. Turkey has been a member of NATO since 1952 and therefore benefits from NATO’s protection despite some sporadic rows. Negotiations to join the EU started in 2005 and were resumed end-2013 after a three-year suspension but progress has been slow. EU accession remains a distant prospect.

Low saving is a drag on growth and contributes to boom-bust cycles

Turkey has weathered the 2008 global economic crisis and the Euro area crisis relatively well despite strong trade and financial ties with Europe. Real GDP growth accelerated to more than 4% in 2013 from 2.2% in 2012, driven by pro-cyclical fiscal and monetary policies. Growth is likely to slow down to less than 2.5% in 2014 amid political uncertainty that exacerbates capital flow reversal and private sector credit and investments. In fact, low domestic saving – one of the lowest in the so-called fragile five countries being Indonesia, Brazil, India, South Africa and Turkey – is a drag on growth and contributes to boom-bust cycles as the country needs to attract external funding to finance investments.

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Despite increasing diversification of exports away from Europe and well-diversified current account receipts, the current account deficit is large. It is expected to reach more than 6% of GDP in 2014, the largest among the fragile five countries. Moreover, the heavy dependence on imported energy and the low saving rate suggest that the current account deficit is structural and therefore difficult to reduce. This is problematic as FDI inflows have been low despite Turkey’s favorable location and its large and growing domestic market. Hence, the current account deficit is mainly financed by volatile portfolio inflows and short-term debt.

Following the US Fed tapering announcement mid-2013 and the episode of emerging market assets sell-off in January 2014, capital flows to emerging markets reversed. Whereas all exchange rates of the so-called fragile five countries - Indonesia, Brazil, India, South Africa and Turkey – depreciated sharply between end April and end August 2013, Turkey and South Africa were the most affected in January. This highlights that the foreign investors are increasingly differentiated between countries. It is no surprise that Turkey’s political issues have amplified economic concerns.

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The central bank interventions weren’t sufficient to stem depreciation pressure in January. Hence, the central bank tightened its monetary policy by sharply increasing its one-week repo rate to 10% from 4.5% end January 2014. As a result, the Lira rebounded somewhat but remains weak. The weak Lira is likely to have a positive impact on external competitiveness and a negative effect on the corporate sector. After all, lending in foreign currency to non-financial corporates has increased rapidly during the last five years, notably in the energy, construction and real estate sectors. Nevertheless the risk must not be overestimated as most of the loans in foreign currency have been granted to companies that generate export earnings, or have financial hedges or FX collateral.

Sound public finances and moderate external debt

Fiscal policy remains accommodative, which further boosts domestic demand and thus fuels inflation and the current account deficit. Nevertheless, public finances are in good shape. Indeed, public debt has been on the decline since 2009, when it reached 46% of GDP, a level still favorable for a country that was close to sovereign default in 2001. Under the auspice of the IMF, Turkey has improved its public finance management. As a result, public debt is low, has a long maturity profile and is mostly denominated in domestic currency.

External debt is moderate at around 50% of GDP in 2013. In the coming years, debt should increase slightly but it should not represent a major risk as debt and debt service should remain at a moderated level. Most of the external debt is owed by the private sector and has long-term maturities even if the share of short-term debt in total external debt has increased over the past few years. Most of this short-term debt is aimed to finance the domestic banks which are increasingly dependent on foreign funding. Despite the increasing reliance on foreign funding, the banking sector should remain stable as it is well-regulated and well-capitalised.

The sharp rise of ST debt in the past five years has put pressure on short-term political risk. Nevertheless, the ST political risk so far remains moderate as it is mitigated by the healthy level of foreign exchange reserves which covered more than 4.5 months of imports in 2013.

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Analyst: Pascaline della Faille, p.dellafaille@credendogroup.com