Be careful what you wish for.
Turkey’s long-awaited restoration to investment grade has the potential to turn into a policy headache for authorities trying to prevent foreign capital from inflating the lira’s exchange rate.
The sovereign was upgraded by Fitch Ratings earlier this month after being classed as a speculative buy for 18 years. If Moody’s also elevates the country to the lower-risk ratings category as expected, its debt will be eligible for inclusion in mainstream global bond indexes – setting the stage for big-money investment funds to take a slice.
New financial market inflows, estimated in the billions of dollars, will provide valuable financing for Turkey’s huge balance of payments deficit and help cut borrowing costs for companies and government.
But there is a downside. Billions of dollars of additional investment flows and a stronger lira could render Turkish exports less competitive in a slowing world economy where demand is scarce and competition fierce.
“This is a nice headache to have but it is a very big headache too,” says Murat Toprak, a currency strategist at HSBC.
“The way the central bank looks at it is: Investment-grade may lead to lower borrowing costs, but the first stage is capital inflows and currency appreciation, and that will cause problems.”
Moody’s said on Tuesday it had kept Turkey’s rating at Ba1, one notch below investment grade, after an annual review, but reaffirmed its positive outlook on the country.
JPMorgan Chase & Co. estimates foreigners have already bought almost $1-billion (U.S.) worth of Turkish lira bonds this month, driving two-year yields down nearly a percentage point to record lows.
Even before Fitch’s Nov. 5 upgrade, foreign funds encouraged by central bank successes this year in taming inflation and the balance of payments gap had pumped $13.6-billion into local bonds, according to central bank data.
Equities too had drawn in almost $5-billion by the end of October, making the Istanbul index one of the best performers of 2012 with dollar-based returns of almost 50 per cent.
The central bank will be less pleased with a JPMorgan client survey that found fund managers have boosted their overweight positions on the lira to record highs. That reflects an implied yield of almost 5 per cent on the currency over the next year, among the highest in emerging markets.
“The lira is one of the currencies you want to have longs on in a sustained manner,” says Jeremy Brewin, a fund manager at Aviva Investors who is overweight Turkish bonds and lira.
But some disappointment may lie ahead. The central bank has swung firmly away from its lira-supportive stance of early this year and is now focusing on weakening the currency by reducing its appeal to foreigners.
On Tuesday, it slashed overnight lending rates, used to supply cash to the market, for the third month running, even though inflation is well above target. It also warned it would cut the main policy rate and the borrowing rate if needed – a powerful signal to any lira bulls.
“You can buy Turkish assets but don’t bet on currency appreciation to increase your returns,” HSBC’s Mr. Toprak said.
The central bank has reason for alarm. The lira has risen 4 per cent against the dollar this year, while in real terms – versus currencies of trade partners and adjusted for inflation – it has appreciated more than 7 per cent.
“The Turkish economy is struggling for competitiveness,” said Manik Narain, a strategist at UBS, noting that a 15-per-cent annual rise in exports was largely down to gold sales to the Middle East, with exports elsewhere largely flat.
Linked to this is worry over Turkey’s current account deficit, which at 7 per cent of economic output is among the world’s highest, leaving the country vulnerable to the ebb and flow of global capital.
While portfolio investments are helping to fill this gap, a stronger lira has the potential to blow it out again to the 10-per-cent-plus levels of 2011, by reigniting credit growth and demand for imported goods.
Aviva’s Mr. Brewin reckons that with Moody’s also likely to move Turkey’s rating out of junk territory, lira bets can only grow.
“They will have to get short-term rates down very low to deter people who think the credit rating is going to improve,” he said.
Foreigners currently hold roughly 20 per cent of Turkey’s bond market compared with 30-40 per cent for investment grade peers such as Poland, South Africa and Mexico.
Barclays says a Moody’s upgrade would make Turkish hard currency bonds eligible for its flagship Global Aggregate bond index, which is tracked by funds managing $6.5-trillion.
Assuming an index weight of 0.14 per cent, Turkish euro bonds could attract $2.0-$2.5-billion in new money, analysts at the bank reckon – considerably more than Turkey is expected to issue in global bond markets next year in net terms.
If lira bonds eventually enter the index, Barclays predicts up to $2.5-billion in new demand for domestic debt, lifting foreigners’ share of the local market to 22 per cent.
Turkish broker Oyak Securities is even more optimistic, suggesting an additional $100-billion in cumulative funding over the next 10 years.
There are lessons, however, for Turkey from emerging peer Indonesia, which became investment-grade in early 2012. Foreign holdings of Indonesian bonds reached a peak of more than 35 per cent but have since fallen to under 30 per cent as the rupiah has weakened and concern has grown over economic policies.
Further Turkish interest rate cuts may also soon become untenable, Goldman Sachs analysts said, adding that the central bank’s dovish stance will “ultimately be undermined by large external imbalances and high and sticky inflation.”