We have been saying recently that investors should prepare for greater volatility as the world’s major central banks start to tighten the spigot of liquidity that has supported not only asset prices, but also the synchronized economic growth globally.
We have also said that investors in emerging markets should be mindful of how these countries will react to this shift while managing domestic risks. The challenge will be different for each country, which will present its own opportunities and risks.
Take Turkey as an example. On Feb. 16, the International Monetary Fund concluded its review of the economy with a warning that it faces the risk of overheating. Turkey became one of the world’s fastest-growing economies last year, with an estimated GDP growth of 6.5 to 7 percent on the back of a generous fiscal stimulus and favorable external conditions.
The stimulus, notably the expansion of a credit guarantee fund to support banks and small and midsize businesses, came after the country was beset with the effects of a failed coup. Meanwhile, the benign external environment benefited Turkey through strong demand for both its export goods and its bonds, which helped finance its support measures, which in turn helped widen its current account deficit.
To be sure, Turkey’s imbalances are lingering issues that make it vulnerable to shifts in investor sentiment and global liquidity conditions. Those structural headwinds are not likely to be fixed in the near term – the IMF estimates that the current account deficit may remain above 5 percent of GDP.
Foreign direct investment has declined, as have government reserves, which the IMF says now covers around half of Turkey’s external funding needs. Meanwhile, inflation has shot up to double-digit rates.
But the balance of risks is gradually becoming favorable, in our view, as the government implements measures to mitigate the side-effects of rapid growth.
To help reduce its budget deficit, Turkey is taking fiscal consolidation measures, including raising the corporate income tax from 22 percent to 24 percent, reducing income tax exemptions, and raising taxes on vehicles and soft drinks. We estimate that the budget deficit will move back below 2 percent this year from 2.2 percent last year.
On the monetary side, the central bank has tightened its policy stance by raising the late liquidity window rate by 50 basis points to 12.75 percent in December, and channeling all liquidity through this more expensive mechanism. This has helped slow down inflation from a peak of 13 percent in November to 10.3 percent in January, supporting real policy rates and the lira.
Meanwhile, GDP growth will likely slow to a healthier level given the more restrictive policies and a higher base of comparison. It should nonetheless outpace most peers in the region, at around 4 percent, given solid business sentiment and consumer confidence. Buoyant external demand, especially from Europe, should be one of the main drivers, supported by a revival in tourism, targeted fiscal measures, and strong investments.
Politics will likely remain a source of concern and volatility given Turkey’s involvement in Syria and tensions with the West. But we see room for hope, as Turkish authorities are making diplomatic efforts to improve relations with both the United States and the European Union.
Domestically, speculation about snap elections has resurfaced, but they are unlikely as we see more drawbacks than advantages for the ruling AKP.
Ultimately, as emerging markets navigate the shifting global tides and manage local risks, investors need to look for the right policy mix that offers good risk-reward. Selectivity is key.
For now, in our emerging market strategy, we remain neutral on Turkish equities and overweight Turkish hard-currency sovereign bonds.
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