Policy experiment puts Turkey at risk

By Time of article published May 26, 2011

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Turkey’s yawning balance of payments deficit and an exodus of foreign investors suggest that its unorthodox monetary policy experiment may have gone too far, threatening to make Ankara a new flashpoint for risk in global emerging markets.

The country’s monthly foreign funding shortfall is running at almost $10 billion (R70bn), data show. It is a tough position to be in when confidence in emerging markets is shaky and Western powers are preparing to wind down easy-money policies.

Financing such a deficit in recent years has not been difficult, with Turkey’s stock and bond markets pumped up by huge foreign portfolio flows, its 2001 financial crash a distant memory. But that picture could be changing.

A Bank of America-Merrill Lynch poll last week showed equity fund managers are underweight in Turkey for the first time in more than three years. Central bank data show non-residents pulled $325 million out of Turkish stocks by mid-May.

A JPMorgan survey showed foreigners have cut Turkish debt and currency exposure this month and gone significantly underweight on its bonds.

“There are very few countries in the world that run such a large current account deficit or are as vulnerable as Turkey to the withdrawal of capital from emerging markets,” said Julian Thompson, the head of emerging markets at Axa Investment Managers.

“It’s sufficiently worrying to have next to no exposure there,” added Thompson, who now has less than 1 percent of the money he manages in Turkish stocks, versus 5 percent last year.

The big issue for many foreigners is a central bank policy experiment that looks to have gone wrong.

In a bid to avoid currency overvaluation, Turkey’s central bank six months ago shocked markets with an interest rate cut, arguing that this would drive out foreign hot money.

To check a domestic credit boom, it raised banks’ required reserve ratios, hoping this would cool the economy down. Turkey wasn’t alone in trying unusual measures – central banks across the developing world used reserve ratios as a policy tightening tool after the so-called currency wars, that were triggered by a second bout of US money printing last year. But unlike Turkey, none went so far as to also cut rates.

“There are risks attached to this strategy because it’s in unknown territory,” said Pierre-Yves Bareau, the head of emerging market debt at JP Morgan Asset Management.

The steps did check lira gains. But by cutting rates the bank may well have reignited inflation in an already overheating economy as loan demand remains brisk. Lower rates also leave Turkey horribly exposed to downturns in global risk appetite. At worst, Turkey risks a market meltdown followed by recession, harking back to its 20th century history of boom-and-bust economic cycles.

Thompson notes Turkish interest rates are half of Brazil’s, yet it has a far greater deficit to fill. “It’s a dangerous game they are playing as the funding environment is becoming less favourable,” he added.

Turkey’s banks, which escaped the 2008 financial crisis unscathed, may also be at risk. Not only do they expect profits to take a 20 percent hit from the hikes in reserve ratios, there are signs they are turning to borrowing to meet unabated loan demand.

A Bank of America client note estimated banks’ short-term external debt at $50bn, twice the pre-crisis peak.

All this has caused Turkish stocks and the lira to lag other emerging markets, with 9 percent equity losses this month alone. Bond yields were up almost 200 basis points this year.

“We get the impression investors have lost patience with Turkey,” said Michael Penn, the global equity strategist at Bank of America. “In many people’s minds the policy experiment has failed.”

Turkey’s central bank said that its steps had helped cut short-term flows and that optimistic credit growth would slow over time, but analysts now think the bank could find itself forced into a policy-tightening U-turn in coming months.

Foreign investors point to buoyant domestic demand fuelling relentless import growth and pushing the deficit ever wider. And nor are high oil prices entirely to blame – non-energy items comprise almost half the deficit.

Investors also note that other emerging market central banks used reserve ratios only as a stopgap. JP Morgan’s Bareau noted that all other countries that increased required reserve ratios followed up with fiscal tightening and rate rises.

In this way China and Brazil have retained investor confidence. the Bank of America survey showed fund managers overweight in both these markets.

The consensus is that Turkey will eventually return to an orthodox monetary policy, probably after next month’s elections.

Forward rates are pricing in 75 to 100 basis points in rate rises this year, while some like JP Morgan even predict 175 basis points in hikes as inflation expectations force a policy U-turn.

Bareau conceded the central bank’s policy may yet work, but he did not plan to stick around to find out. He sold his Turkish bond positions last week and is now underweight. – Reuters

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