Turkey: Regulatory audits and inflation are new threats
Once the darling of financial investors, Turkey now sees its brilliant investment story rapidly losing its luster. Two new risks have emerged, which may soon compel many long-term funds to trim positions, or worse. As the social unrest sparked by the Gezi Park controversy continues, the ruling Justice and Development Party (AKP) is increasingly leaning towards a comprehensive crack-down on what it considers a conspiracy to topple its regime. It believes that a “High Interest Rate Lobby” is the culprit behind the June selloff, with regulators being ordered to investigate everyone who sold positions. The prospect of penalties against brokers or financial investors is the first new risk. June CPI climbed from 6.5% to 83% year-on-year, rendering the CBT’s year-end target of 5.3% meaningless. However, the CBT refuses to acknowledge the accumulating pricing pressures, which is the second new risk. Turkey is at the top of the list of countries that will be hurt by a continued exodus of financial capital. The impression that the AKP doesn’t care about financial investors, or the CBT about inflation, is very damaging for the country’s balance of payments outlook. SGA reiterates its underperform rating.

Regulators on a witch hunt
Over the last few weeks, we reported with growing concern that the AKP is tending to blame the Gezi Park protests on a coterie of evil-minded forces, such as the international press, global financial speculators, and the vestiges of the former regime. As crowds spilled onto the streets of Istanbul once again over the weekend, the AKP’s determination to end this “conspiracy” is being reinforced. One aspect of this policy of combat is of particular concern to financial investors. Turkey has created the myth of the High Interest Rate Lobby—a mythical creature, part Turkish, part foreign institutions—whose players are colluding to undermine political and economic stability and benefit from the resulting lower prices/higher interest rates.

This construct is so baseless, we refuse to comment on it. However, apparently it is being taken seriously by the government. The Capital Markets Board (CMB), a government watchdog, has been instructed to investigate all trades on the Borsa Istanbul (BIST) during the Gezi Park crisis. We have press reports of the BRSA, the coup trial DAs, and even Turkey’s anti-money-laundering agency, MASAK, jumping into the investigation. Over the weekend, newspapers close to the AKP claimed that a new inquiry may start targeting Citi and Deutsche Securities over a custody transaction. Our contacts in the country confirm that a very meticulous audit is in progress, covering all funds that have positions in the financial markets. Many are worried that one or a few major names will be found guilty to “teach a lesson” to speculators. We are not in a position to assess how the AKP feels about punishing the very source of Turkey’s well-being, namely the financial investor. We doubt it will go as far as suing major brokers or funds, but we feel it is our duty to inform our clients so that they can seek legal advice if they share our concerns.

Investor panic could cause balance of payments problems
Turkey has received $50 billion of new investment into its F/X, bond, swap and equity markets over the last 12 months. According to our reckoning, up to 90% of these funds remain invested in Turkey, which is still one of the most “overweight” countries in the emerging-market universe. Over the past year, we forecast the current account deficit having reached $52.3 billion (May data is to be released on July 11), which means that portfolio investment covered it entirely. At a time when the durability of emerging markets as a permanent asset class is being questioned, it is very risky to spook foreign investors with fictitious inquires. If external conditions or CMB inquiries cause panic among foreign investors, the CBT doesn’t have the resources or the tools to defend the lira.

CBT: Ignoring inflation at its own expense
CPI rose from 6.5% to 8.3% in June, with the CBT claiming it was driven by larger-than-normal price increases for unprocessed food and transportation. It is advising the markets to take the high number in stride because CPI will decelerate in the coming months. This is a superficial and misleading analysis. First even though the 8% June depreciation of the lira against the synthetic euro-dollar currency basket barely passed through to core prices, the CBT’s favorite proxy, the I sub-index, began inching up. It is currently at 5.6%, but is expected to climb towards 7% in the coming months. Secondly, service prices, largely under its control, are rising at a rate of 8% per annum, meaning clearly that monetary policy is too loose. Yet SGA and a majority of researchers believe that the CBT is stuck between rising inflation and lethargic growth and would be very disinclined to raise policy rates or broaden the “rate corridor.”

If we are correct, the hands-off approach is a very questionable practice at a time when runs on the lira are developing almost every week. The CBT is trying to defend the currency by selling rising amounts of F/X. Given its meager “usable” F/X reserves of $20–25 billion compared with a portfolio investment stock estimated at $120 billion, currency interventions could create self-fulfilling expectations of new rounds of devaluation. Devaluation immediately spreads to core inflation, as will become painfully obvious in the next few months. However, if inflation were to rise further, the currency will need to adjust downwards, which would force the CBT to sell even more F/X. In short, if the emerging-market exodus continues, the CBT’s current stance could lead to a vicious cycle of a lower lira and higher inflation.

Moreover, some of our local contacts suggest that the CBT is aware of this bad-case scenario, but delays rate hikes in fear of a public backlash, or warnings from the AKP. SGA can’t confirm whether political pressure plays a role in the Bank’s “reaction function,” but its overly benign interpretation of inflation suggests something is amiss here. At the very least clients should wait until the CBT adjusts policy to fit the new world realities before increasing positions.