One Day the EU Will Apply to Join Turkey

I've spent the last couple of months an investment bank in Bahrain which had (past tense) an ambition to ally the surplus capital of the Gulf region to the financing opportunities presented by the historic emergence of Turkey and its near neighbours. To my mind, that was (and is) a hugely inviting prospect. Istanbul is one of the few cities that can claim to be the centre of the world, and right now hosts an alliance of demographics and growth that I remember from the great Asian emerging markets of 20 years ago. The long and short of it is that Turkey is a country of 74+mn, with a median age of 28.5 years, a per capita income averaging around US$10,300. Over the last decade its real GDP growth rate has averaged 5.3%, but it's been a rough old journey, with a standard deviation of 4.4%.

Growth, opportunity and volatility – what's not to like for an emerging market investor?

Right now, it looks as if 2012 will be another rocky year, with investors needing to take a view on how far Turkey overheated last year, how quickly it is rebalancing its economy between domestic demand and exports, and how much appetite world markets have to keep financing Turkey's investment spending. My sort of questions, in other words. (Incidentally, I expect the usual suspects will markedly underestimate the capital appetite for Turkish risk at this point: the key datapoint being the 110% jump in FDI – the world's stickiest money – last year).

My starting point is, as usual, to run the Flow Essentials charts to get to the underlying ratios Turkey's economic growth and financing depends on. Start with estimated growth of capital stock and the direction of ROC. My assumption is that when you've got a rapidly expanding banking system (loan growth of 42.3% last year) you must have significant misallocation of resources, disguised temporarily by inflation (up 6.5% on average in 2011, and rising sharply, to 10.6% YoY in January). But even using deflated numbers, on my count capital stock is growing around 8.6% pa (or 16.5% nominal), but ROC was no worse than flat last year.

And this was borne out by the monetary velocity reading, which again was no worse than flat.

This was a genuine surprise: the expected misallocation should have shown up far more starkly on these charts.

Still, leverage must have been rising sharply, and banking data tells us that banks' loan/deposit ratio rose from around 80% at the beginning of the year to 89% by the end of the year, and that this had been financed at least in part by an increase in foreign liabilities from a net US$16.74bn at the beginning of the year to around US$20.4bn by the end of the year. But once again, one would have expected the rise in leverage of the banking system, and is escalating exposure to the jitters of its foreign liabilities to be more extreme. Run the numbers, and it turns out that only 9% of the rise in the loan book was funded by the net increase in foreign liabilities – slightly less than the 11.2% that was funded by banks' running down their holdings of domestic securities.

But in the end, we cannot escape the fact that even if Turkey's rapid 2011 growth has been driven by rather less inefficient resource allocation than we had expected, and even if the financing of the growth was rather less reckless than it might have been, Turkey's growth was still powered by a major private sector savings deficit. In fact, I estimate that that deficit came to 8.7% of GDP in 2011.

And here is the rub: judging how far and how fast that savings deficit is being corrected this year is surely the key to potentially one of the most exciting turnaround stories of the year.

Yesterday Turkey reported that it ran a current account deficit of US$5,998mn in January, slightly down from US$6,565 mn in December, and US$6,022mn in January 2011. Nonetheless, this was taken as a slight disappointment (consensus had expected a deficit of only US$5,500mn for the month), because the monthly improvement was only approximately half the improvement of the trade balance. The surplus on 'invisibles' amounted to only just over US$1bn, which was 24.1% less than in January 2011. Part of the reason for this, no doubt, was the stalling of the tourism trade: tourist arrivals rose only 0.6% YoY in January – no doubt reflecting Europe's straitened economic circumstances.

So far so gloomy. However, what matters for Turkish financial markets right now is the extent to which, and the pace at which, it winds back the private sector savings deficit which ballooned to around 9% of GDP last year. Movements in the current account are a crucial part of this calculation, and here the news is distinctly better.

In nominal terms, the 3m private sector savings deficit hit bottom in May 2011 at Tkl 33.99bn, and has since moderated. That progress was continued during January. In the three months to end-Jan, the PSSD improved to Tkl 26.57bn – only Tkl 2.38bn above where the balance was the same period last year.

Private sector savings surpluses and deficits usually have a distinctive seasonal pattern (as do current account balances, and government fiscal balances) so we can also assess how current changes in private sector savings flows compare to 'normal' conditions. And, as the second chart shows, when judged on this basis, Turkey's private sector savings cashflow position continues to improve, with the pace of improvement having picked up noticeably in the three months to both December and January.