Investors see investing in Turkey in a favourable light

Despite challenges with its EU ascension campaign, myriad reforms and recent success have made investing in Turkey an attractive choice.

Fueled by prudent macroeconomic policies and structural reforms, Turkey is currently the fastest-growing country in the Organization for Economic Co-operation and Development. And this, combined with reasonable valuations relative to its emerging markets counterparts, is putting Turkey in a favourable light with investors.

But even though Turkey is experiencing the longest stretch of economic expansion in its history, the country’s short-term record of responsible macroeconomic policies leaves it vulnerable to external shocks. In addition, its potential ascension to the European Union is taking longer than expected, which is delaying the benefits of convergence and creating some uncertainty in the minds of many.

“Turkey is beginning to look interesting. In spite of its risks, valuations are reasonable compared with other emerging markets,” says Chuck Wong, portfolio manager at Dynamic Funds Management Ltd. in Toronto. “Entry into the EU will be a catalyst for Turkish stocks.”

Recent growth in Turkey comes on the back of decades of high inflation and recurrent boom/bust cycles. A financial meltdown in 2001, precipitated by a banking crisis, led to its rescue by the International Monetary Fund, which forced the country to implement a reform package to stabilize the economy. As part of its deal with the IMF, Turkey abandoned its “crawling peg” exchange rate regime, restructured its banking sector, streamlined public-sector employment, broadened the tax base and agreed to implement a series of macroeconomic reforms.

Since the 2001 crisis, which led to a 7.5% contraction in gross domestic product, Turkey’s economy expanded by 33.5% on a cumulative basis between 2002 and 2005 and by almost 6% last year. Growth is forecast to slow in 2007 to around 4.5% before picking up again in 2008.

At the same time, inflation has fallen steadily, reaching single digits in 2004 for the first time in three decades, down from a peak of 70% in early 2002.

Economic growth is being driven by several factors, says Mark Mobius, portfolio manager with Templeton Asset Management Ltd. in Hong Kong. An increase in per-capita spending is driving domestic consumption, while falling long-term interest rates are stimulating growth in consumer credit and demand for big-ticket items such as automobiles and housing.

“Exports to Europe continue to grow fast,” he adds, “and that means more money flowing into the country, although imports are growing as fast.”

Tourism also continues to do well and has not been impacted by the bird flu scare, Mobius says, while massive foreign direct investment in local financial institutions are having an influence on money supply growth.

Incidentally, Turkey’s banking sector has been a major attraction for foreign institutions, resulting in 10 major deals worth almost US$6 billion in 2005. Privatization of state enterprises has also gained momentum in recent years, with total revenue from the sale of state assets in areas such as telecom, energy, port operations and hotels totalling almost US$17 billion in 2005.

During the same year, foreign direct investment also rose substantially, amounting to approximately US$10 billion, compared with a total of only $22 billion between the mid-1950s and 2004. As well, consolidation among domestic companies across almost all sectors have taken off, triggered by EU entry talks.

Although Turkey has been implementing reforms for more than two decades, its attraction to foreign investors was heightened in 2002, when its potential entry into an enlarged EU seemed more plausible. Turkey’s recognition in 1999 as an official candidate for ascension to the EU followed a series of agreements dating back to 1963, when it signed an association agreement with the European Economic Community (the precursor to the EU). Turkey became part of the General Agreement on Tariffs and Trade in 1985, then signed a free trade agreement with the European Free Trade Association in 1991 before entering into a customs union arrangement with the EU in 1996.

These trade-related initiatives were accompanied by the abolition of price controls and subsidies, greater flexibility in exchange and interest rates, trade liberalization, export promotion and reduced import barriers — all designed to create a more open economy.

In fact, Turkey is regarded as the sixth most open emerging market, just behind Mexico.

In spite of its progress, Turkey’s EU ascension talks have dragged on — largely a result of its political conflict with Cyprus, which is a member of the EU, and the need for more political, social and regulatory reforms.

In addition, support for Turkey’s ascension has been declining among EU member states. Arguably, 95% of Turkey is in Asia, which means that the boundaries of the EU would be eroded if Turkey becomes a member, potentially opening the door for non-European countries such as Morocco, whose application to seek membership was rejected.

The identity of the EU, which was built largely on Christian values, would also change with the acceptance of a predominantly Muslim state. Conversely, Turkey straddles the borders of Europe, Asia and the Middle East and so provides security advantages, which proponents for its membership see as significant.

The debate over Turkey’s EU membership has hurt its attractiveness to investors. “Investors have moved from being excited about Turkey’s entry into the EU to being unsure about its prospects,” says Pablo Salas, managing director and senior portfolio manager with Trilogy Global Advisors LLC in Orlando, Fla., who manages CI Emerging Markets Fund. “Now they’re re-rating Turkey because convergence is set to take longer than expected.”

But even though slowing EU ascension talks may raise investors’ concerns, Turkey’s failure to converge with the EU does not pose any risk to the country as a whole, Mobius says: “There is no risk attached to Turkey not getting into the EU. It already has had access to European markets since 1995 and its economic ties to Europe continue to grow.”

In 2005, more than half of all of Turkey’s exports headed to the EU countries, then numbering 25.

Although the performance of Turkey’s economy was relatively strong last year, its stock market was weak. The MSCI Turkey index lost 9.2% in U.S.-dollar terms in 2006, compared with a gain of 29.2% for the overall MSCI emerging markets index.

However, Turkey’s 10-year performance is significantly greater than that of the broader index, while its three- and five-year performance is comparable. Over the three-, five- and 10-year periods ended Dec. 29, 2006, the MSCI Turkey index returned 24%, 21.9% and 12.5%, respectively, compared with the MSCI emerging markets index’s 27.3%, 23.5% and 6.7%.

Salas says Turkey did not recover as well as other emerging markets following the May-June 2006 stock market sell-off in those markets that was prompted by interest rate hikes in major industrial countries and which led to a shift in the risk appetite of international investors. According to a 2006 OECD economic survey of Turkey, the country was most affected because its large and widening current account deficit was fed by large capital inflows, including a large share of portfolio capital, which had fuelled an appreciation of its currency. In addition, it was vulnerable to economic shocks because of its short history of macroeconomic stability, the need for greater independence among key institutions and for further reforms, as well as the emergence of political tensions. As a result, says Salas, valuations have fallen, making stocks attractive.

Adds Mobius: “Investor confidence in Turkey has improved significantly since the May-June correction, with foreign direct investments and portfolio inflows totalling US$24 billion in the 12-month period ending October 2006.”

Another positive development is the release of a US$1.1-billion IMF credit tranche in December as part of an ongoing support program, Mobius says, which reflects Turkey’s achievement of specific macroeconomic targets such as its lower budget deficit, which has declined from about 16.5% of GDP in 2001 to about 1% in 2006.

Turkey has “some pretty good companies” with “decent” market positioning, sound balance sheets, strong management and good transparency that are “trading at a significant discount to other emerging markets,” says Salas. “It is a good European market to be in, and it is similar to Mexico with low-cost access to larger markets.”

Salas sees opportunities in sectors such as banking, breweries, wireless/telecom and oil refining. Mobius likes the consumer, banking and tourism sectors, while Wong also favours the banking and consumer sectors.

Canadians seeking to invest in Turkey can do so through mutual funds that have an exposure to this market, such as CI Emerging Markets Fund, Templeton Emerging Markets Fund and IG Mackenzie Universal Emerging Markets Fund. As well, the Bank of New York ADR index lists 39 American depository receipts issued by 27 Turkish companies.

“There is concern regarding Turkey’s large current account deficit stemming from the strength of the currency,” says Mobius, a view that is shared by Wong and Salas. Heavy reliance on short-term capital flows, along with currency volatility, high interest rates and political uncertainty, also leaves the country vulnerable.

The OECD survey states that the Turkish economy is still vulnerable and needs reforms to cut regulatory and tax burdens, which have stifled business growth, deterred foreign investment and acted as barriers to formal employment. It warns that the current recovery was aided by a favourable international environment characterized by strong world trade, low interest rates and an appetite for emerging markets assets.

However, Turkey’s reforms have not yet been consolidated and, the OECD report adds, the country “remains highly vulnerable to the whims and changing risk appetites of international investors.”

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

More articles by Dwarka Lakhan