Description

Short idea: TUR

EXECUTIVE SUMMARY  

• Turkey’s GDP grew at 9% a year over the past decade, and its stock market was up 60% in 2012. Meanwhile its government debt is only 40% of GDP. Turkey seems like it's healthy and getting healthier. In reality it’s in danger of collapse.

• With government debt so low, Turkey seems to have spared itself the debt troubles other countries have. But the problem isn’t public debt. It’s the explosive loan growth of 32% a year in the private sector.

• Credit growth is a wonderful thing when the money goes into productive assets. Turkey’s loans aren’t. They’re funding consumption.

• Turkey has a Greek-size current account deficit of 9% of GDP. It also has scary-high loan growth that it can’t—or won’t—slow down.

• To fund the current account deficit, Turkey has in just a few years ramped up short-term external debt to $110 billion or 14% of GDP. Even worse, almost half of this debt is in the most fickle form of short-term financing: interbank borrowing. This money could be yanked from the economy in weeks, not months.

• For reasons discussed below, we believe there is a strong likelihood this money will be pulled from Turkey’s economy over the next year. As a result, Turkey is in danger not of a correction but a collapse.

• We recommend minimizing exposure to Turkey’s economy, particularly its banks, and/or shorting the Turkish lira or the Turkish stock market (TUR).

IMPORTANT TO REMEMBER WHAT KIND OF ECONOMY WE’RE DEALING WITH

Turkey is an emerging market economy and while much is made of the growth of these economies, there are still extremely negative aspects to them. For instance, Turkey has a high level of corruption and—more important—a low net worth both on an absolute basis and relative to its GDP. 

Turkey’s GDP is $770 billion. But according to Credit Suisse, Turkey’s net worth in 2011 was only $1.3 trillion—meaning it has little economic surplus of its own to invest. And the net worth of its financial assets in 2011 was only $250 billion. When financial net worth is only a fraction of total net worth, the marginal value of additional financial assets is very high. Conversely losing financial assets is very painful. And that is precisely the future Turkey is facing.

One other thing I should mention: Turkey has been hailed as a miracle of the Middle East. But as a June 4 article by Michael Rubin in the WSJ makes clear, there is a significant amount of political risk involved in investing in the country. It jails more journalists than any other country in the world, according to Reporters without Borders. Also Kurds form about 25% of the population, and the tension between them and ethnic Turks at times reaches "civil war" heights.  This is to say nothing of course of the recent protests going on.

DEBT-FINANCED CONSUMER BUBBLE

Since 2007, total loan growth in Turkey has averaged 32% a year and consumer debt has increased 31% a year. Total loans are now 60% of GDP and 180% of Turkey’s financial net worth. Why is this a problem? The money is going towards consumption, not into growing Turkey’s asset base. Turkey isn't using the money to get richer. It's using the money to get poorer. Over the same period, imports of capital goods have only grown 5%. And in 2012, imports of capital goods dropped a staggering 9%.

Meanwhile Turkey is run-rating a current account deficit of $70 billion or 9% of GDP. This is reminiscent of Southern European countries pre-crisis and is just not sustainable. Keep in mind the deficit has been going strong since 2011, so at this point the deficit is structural in nature.

In 2012, things seemed to get better when the current account deficit dropped to $50 billion, but the reality is imports never came down and the improvement in the deficit was largely a function of Turkey exporting gold to Iran to help it circumvent U.S. sanctions. This wasn’t actual reform, and the U.S. government has since put a stop to the practice.

What is so scary about the loan growth and the size of the current account deficit is that there seems to be no way to reduce them. In 2012, GDP growth flat-lined, growing only 2% compared to growth of 9% in 2010 and 2011. Yet at the same time, loans grew at 20% and imports never decreased. So in other words, Turkey’s eyes are officially larger than its stomach.

It gets worse. As one commenter David Goldman has pointed out, consumer spending didn’t increase in Q1 2013 and barely increased in 2012. Goldman by the way has great research on Turkey available at Asia Times.com. By my calculation, in 2012 consumer spending increased only 6% or about $9 billion. Contrast that to absolute loan growth of $70 billion. So GDP flat-lines and consumer spending increases only modestly, yet there is massive loan growth. Where did the other $61 billion borrowed go?

One place where it didn’t go but should have was CAPEX. In the first quarter of 2013, capacity utilization came down 1% yoy. Since it’s unlikely manufacturers would pay for CAPEX while cutting down on production, it makes sense to conclude much of the $61 billion in borrowing did not go into growing Turkey’s asset base. As a sanity check, capacity utilization for the manufacture of investment goods declined in 2012. Also as mentioned before, capital goods imports dropped 9% in 2012 yoy.

So we’re back to our original question. Where has the borrowed money actually gone?

Turkish borrowers may already be capitalizing interest. When we look at the data, we see a disturbing trend. Interest rates have been dropping since 2011 and yet we see delinquencies rising sharply. Loan delinquencies net of recoveries doubled in 2012 and are on pace to increase 80% in 2013. This suggests the worst-case scenario could already be underway.

Turkish borrowers are likely already capitalizing interest and depending on refinancing to stay afloat. If that is what’s happening and if it continues, there’s nothing Turkey’s central bank can do to stop the shock to the financial system.

WHAT CAN TURKEY DO?

Turkey doesn’t have the luxury of “extend and pretend.” The fact is its banks have become so dependent on interbank borrowing that Turkey’s hands are tied.

If Turkey raises interest rates to stop the growth of loans that can’t be repaid, the debt burden on households and businesses would cause a wave of defaults. How do we know this? Because it’s already happening. Even with historically low interest rates, loan delinquency is accelerating.

Now imagine if loan growth slows and refinancing is no longer available? You see a repeat of what happened to sub-prime borrowers in 2008. 

So if you can’t deflate a financial bubble, what can you do? Perhaps Turkey could do what the developed world is doing and use monetary easing and lower interest rates to “financially repress” its way out of indebtedness.

Well that is to say, it could have. Now it’s too late—because it’s already racked up $110 billion in short-term external debt (14% of GDP and 44% of the country’s financial net worth). S&P has a good write-up on this (http://www.standardandpoors.com/spf/upload/Ratings_EMEA/2012-12-05_LoanGrowthAndLowDomesticSavings.pdf). Any devaluation of the currency would spark capital flight which—due to the rapid rise in interbank borrowing—could take place over days, not weeks. This would end Turkey’s credit bubble--but at a horrible cost.

Plus Turkey has recently had major problems with inflation. In 2011-2012, inflation jumped from 6% to 11% in just four months. Now that GDP growth has stalled and loan growth has continued unabated, conditions are set for the return of inflation.

Over the past three years, Turkey’s central bank has grown its balance sheet by 25% a year. In fact, back when the central bank was at least paying lip service to slowing loan growth (and dealing with inflation), its balance sheet continued to grow at double digits. In other words, they were loosening monetary policy even while they told everyone it needed to be tightened. Why do you think that is? Something is wrong in the state of Turkey, and I suspect the central bank is well aware of the problem with the bank’s loans. They probably believe inflation is preferable to a sharp rise in defaults.

Just over the past year, the balance sheet grew 50% and is now $130 billion. On April 14, the central bank announced it was cutting short-term interest rates by 50 bps. Clearly they’re trying to re-start GDP growth, but they are possibly going to produce inflation in the process. In fact inflation is something which Turkey’s powers-that-be have consistently indicated they’re not concerned about. In 2011, the Minister of the Economy Zafer Caglayan indicated a weak currency was “no concern” because it helps exports. We’ll see about that.

Turkey is damned if it does and damned if it doesn’t. And whether it’s inflation or borrower defaults that spooks investors, it will be the sharp reduction in interbank borrowing that likely brings the bubble to the end.

Catalyst

• Turkey continues cutting interest rates to stimulate the economy and pretty much does nothing to slow credit growth. Inflation becomes a problem like it was in 2011, and foreign interbank lenders pull their capital, thus causing a shock to Turkey’s financial system.

• Turkey is forced to raise interest rates to stop loan growth, and Turkish businesses and consumers lose the ability to refinance. Defaults, which are already on the rise, increase even more sharply. 

• Continued political strife draws attention to Turkey's structural problems.