Turkish Bonds Look Delightful

You may not get another chance to buy Turkish bonds at 15%. With Turkey's economy and financial markets making rapid improvements, the yield curve is far too steep in relation to economic conditions.

Investors are unlikely to get another chance to buy Turkish bonds at 15%. A few years ago, we published a report on Israel entitled Buy Bonds, Wear Diamonds, recommending that investors buy domestic bonds trading at 12% in nominal terms. Today, if you are lucky, you can get long-term Israeli bonds called Shahar or dawn' in English at around 6%. Even after such a remarkable compression of interest rates, we still like Shahar bonds and think that Israel's yield curve is too steep in relation to economic conditions. But we have even a better investment idea: Turkish bonds offering a 15% return.

Buy Turkish bonds: economic normalisation

Turkey's economy and financial markets have come a long way in the past three and a half years. Defying catastrophic predictions, the normalisation of the political and economic landscapes has lowered bond yields from an average of 91.7% in 2001 to the lowest level in two decades.

And, now, as the country is set to move forward on the predictable course of EU accession, we see bonds at 15% soon becoming an anecdote in financial history. Hence, do not listen to fearmongers with cataclysmic speculations and bizarre conspiracy theories and buy some Turkish bonds. And then, if you wish, you will be able to wear diamonds of your choice.

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Structural breakthroughs form the foundation for our positive assessment. Turkey's economic recovery and financial turnaround in the aftermath of the devastating crisis are based on a credible, and coherent, set of prudent fiscal and monetary polices and far-reaching structural and institutional reforms. With the diminishing risk of political fragility, the country's new economic policy framework has cleared and widened the horizon for real and financial investments.

Take, for example, the pace of post-crisis output growth. Turkey is not only experiencing its longest stretch of economic expansion at a rate well above the historical trend, but also, more importantly, it is becoming significantly less volatile. Our time-varying volatility calculations confirm this critical point for all macroeconomic variables, including inflation rates. In other words, structural breakthroughs in politics and economics have carried the Turkish economy into an age of stability' that will, in our opinion, continue to push its potential growth rate to a higher plateau.

Buy Turkish bonds: strong growth

Economic stabilisation supports our recommendation to invest in long-dated bonds. Thanks to a variety of fundamental factors including fiscal consolidation that has driven interest rates lower and reduced the crowding-out effect of public-sector borrowing, Turkey has enjoyed an unusual mix of strong growth and rapid disinflation towards the single-digit territory.

Real GDP posted an average year-on-year increase of 7.2% in the last 14 quarters, which is almost twice as much as the trend growth rate of 3.9% in the 1990s. Even though our analysis suggests that the economy's potential growth rate is now closer to 7.0%, we do not expect to see such a reading in every single period going forward.

Accordingly, the stabilisation of growth dynamics, after expanding by a staggering 25% in the past three years, is a healthy development and does not herald a recessionary period in the coming periods. Real GDP is in fact still growing, on a seasonally adjusted basis, compared to previous quarters and, on our projections, will register an annual increase of 6.2% in 2005 and 6.5% next year. Against the worst global energy crisis in decades, stable growth should help to achieve ambitious inflation targets in the coming years and thereby lower long-term interest rates

Buy Turkish bonds: rapid disinflation

The global energy shock will not derail Turkey's secular disinflation. The consumer price index posted a cumulative increase of 2.9% in the first eight months, lowering the 12-month inflation rate to 7.9% in August. In a country that was, just a few years ago, on the verge of hyperinflation, such a rapid disinflation is a big success. Indeed, the annualised inflation rate implied by consumer prices excluding the energy component and changes in indirect taxes declined from 9.5% in 2004 to 5.8% in the first half of 2005 and to -4.8% last month.

Although our global projections highlight a period of high energy quotes, we believe that secular forces behind Turkey's disinflation process will continue to be the ultimate drivers of inflationary dynamics. First, the economy is operating with an output gap and slack in the labour market. Second, labour productivity growth remains well above historical averages, effectively putting a cap on unit labour costs. Third, competitive pressures in sectors open to international trade limit pass-through effects from producer prices (and even a weaker currency) to consumer prices. And, finally, multi-year fiscal targets and an incomes policy that is consistent with the central bank's inflation targets will remain supportive. Accordingly, we expect the Central Bank of Turkey to cut short-term interest rates by 75 basis points to 13.5% by the end of this year.

Buy Turkish bonds: public sector reform

Fiscal consolidation will lower the budget deficit below the Maastricht criteria. According to EU-defined metrics, Turkey's budget deficit declined from 12.3% of GDP in 2002 to 3.9% last year. And the latest statistics show that the primary budget surplus in the first eight months reached 93.8% of the year-end target, helping to keep the overall budget deficit at 23.2% of the annual target. Even accounting for seasonal factors that usually lead to higher spending in the fourth quarter, fiscal consolidation remains on track.

Of course, Turkey's public-sector budgetary performance in the future will largely depend on the progress of social security and tax reforms. In our view, witnessing the interaction between lower interest rates and fiscal sustainability as well as overall macroeconomic performance that has been clearly evident in the last four years, the authorities will remain committed to the multi-year budgeting process that diminishes fiscal dominance and improves debt dynamics. With growing momentum in the privatisation of state-owned enterprises and other assets, the public-sector budget deficit looks likely to turn into a small surplus by the end of 2007. This means that the Treasury will borrow less and less from capital markets and may even make larger-than-planned repayments to the IMF.

Buy Turkish bonds: EU accession

Despite all the noise, we have maintained our view that Turkey will start accession negotiations with the EU, as scheduled, on October 3, 2005. Recent developments leave no doubt about the forthcoming progress that will, in our opinion, accelerate Turkey's institutional convergence and reinforce the stabilisation of macroeconomic dynamics. Accession negotiations will be long and challenging, but also complement Turkey's structural adjustment by functioning as an anchor' for policy-making and by attracting direct investors and a new class of portfolio investors with a wider investment horizon.

The recent success on the privatisation front is a case in point. Together with the normalisation of the political and economic landscapes in the past three and a half years, the prospect of EU membership has already raised Turkey's privatisation revenues from an annual average of $454 million in 1986-2003 to about $20 billion so far this year. The resulting inflow of foreign direct investment not only reduces the reliance of short-term financing options, but also accelerates the process of capital accumulation that will stimulate productivity growth and raise the ceiling of the country's potential growth rate.

The value of Turkish bonds stems, beyond the easing cycle, from an improving risk profile. Turkey was a perfect example of how underlying structural problems make a country extremely sensitive to event risks. However, we believe that the risk of exogenous developments turning into an endogenous shock has diminished dramatically. And, now, with the start of membership talks with the EU, we expect the accumulated macroeconomic gains to lead to multiple rating upgrades towards investment-grade status.

Buy Turkish bonds: they'll deliver diamonds

That should, of course, help to break mental inertia and reinforce the downward trajectory in real interest rates. In turn, the upward shift in the maturity profile of the Treasury's domestic debt stock will lower the burden of interest payments, which already declined from 23.5% of GDP in 2001 and to 13.2% last year. Therefore, even if you disregard the long-term value of institutional convergence, Turkey's improving debt dynamics alone should deliver diamonds to bondholders as well as equity investors.

By Serhan Cevik, Morgan Stanley economist, as published on the Global Economic Forum