Be bullish or be late

A number of factors, domestic and foreign, have contributed to Turkey’s recent success. A government with a strong majority (a rarity in Turkey) has imposed some budget discipline and pushed through structural reforms that have been essential in revitalising the economy. On the foreign side, the IMF and the EU have anchored both the economic and the political reform progress.

The role of the extremely benign global financial environment cannot be overemphasised. The country has benefited from ‘global disinflation’ in spite of increasing commodity and oil prices. In terms of global liquidity, capital flows have pushed interest rates down, thereby enabling rapid growth in consumption and investment whilst also greatly spurring the Treasury’s debt dynamics. Thanks again to capital inflows, the New Turkish Lira appreciated in both real and nominal terms, thereby enabling disinflation despite high GDP growth rates and forcing local producers to enhance productivity. On the other hand, in 2006, Turkey has seen some deceleration in growth, which might or might not prove to be transitory. Many agree that a little slow down would be good for its external balance. Inflation has remained at around 8% since the start of the year. Fiscal discipline is not as tight as it used to be and the current account deficit is growing at a worrisome pace. The unemployment rate has not been falling despite high GDP growth. On the political front, presidential elections are on the agenda for May 2007 and parliamentary elections are scheduled for November of the same year. There have also been circulating rumours of early elections as soon as October 2006, even though the current single-party government has repeatedly assured that early elections are not a possibility. With global interest rates rising, concerns about disinflation reversing are being brought to light. Domestically, the outlook is not as bright as it used to be due to the current; presidential and parliamentary elections in 2007, unresolved Cypriot and Kurdish issues and EU accession procedural difficulties are all major worries.

The Turkish banking sector attracted over $6bn (€4.7bn) in foreign capital in 2005 and is expected to grow at an average of 8% per year between 2005 and 2020, by when its total assets are estimated to reach $790m (see Banking article). Potential rewards for investors include relatively high margins in a large and fast-growing market, particularly in retail banking. The level of financial intermediation is still very low as private sector loans to GDP are only 21%, and the ratio of retail loans to GDP is about 10%. The drop in inflation and interest rates has sparked a vast demand for consumer borrowing during the past two years.

Encouraged by the strong economic growth and measures taken within the Banking Sector Restructuring Program, which was intensified in response to the 2001 financial crisis and backed by the IMF with multi billion dollar loans, the banking sector has made remarkable progress over the last five years in developing its risk management abilities. A new Banking Law was enacted in October 2005. It acts as a structural benchmark for the current Letter of Intent to align the legal framework more closely with EU standards. Turkey’s EU convergence process should underpin further economic and institutional reforms while exercising a stabilising force over the banking system. Yet, it is the government’s continued commitment to the reform process that will sustain the current positive climate.

During the EU harmonisation process and the adjustment of the regulatory framework and operational ratios to international standards the market has begun to experience some stability. The total assets of the banking sector at the end of 2005 were at $295bn, an increase from $130bn in 2002.

State banks have undergone a process of recapitalisation and restructuring. The process of privatisation of the two large state banks, Halk Bank and Ziraat Bank, has removed the need for short-term financing and lifted the pressure off of the domestic market. Due to their liquidity surplus, state banks are now providers of liquidity to the money market.

With most Turkish banks reporting strong growth and returns, the profitability of the banking sector as a whole has improved dramatically. Less market-sensitive income is a sign of progress for the general quality of earnings.

Substantial improvements have been made following the operational and financial restructuring programme. The ratio of public debt stock to GNP as per the Maastricht criteria of 60% has been decreased. The market has seen a consolidation in the banking sector with a declining share of state banks. The levels of financial risk have been reduced significantly. The sector is now under stricter supervision by an independent regulatory board. In turn, transparency has improved and banks enjoy stronger capital structures while tighter regulations help them move towards international standards.

With increased economic and political stability and encouraged by the prospect of eventual EU membership, international banks are seeking opportunities in Turkey. 2005 was a memorable year for international acquisitions since international banks paid a total of $6bn to enter the market. US General Electric Consumer Finance’s acquisition of a 25.5% share of Garanti Bank, Turkey’s fourth biggest commercial bank, for $1.56bn was the highest transaction in the sector in 2005. This has already been surpassed in 2006 by the National Bank of Greece’s bid to buy 46% of Finans Bank for $2.77bn and Dexia of Belgium agreeing to buy 75% of Deniz Bank for $2.44bn.

At the end of 2005, despite all the acquisitions, only 12.5% of the banking sector was in foreign hands. This figure is, however, very low when compared with over 90% in several Central and Eastern European countries, particularly in the new EU members.

Hakan Ates, CEO of recently acquired DenizBank, deems that “foreign presence in the Turkish banking sector will continue to grow rapidly”. He also added that “the prime targets are smaller banks, with their discounted prices over book value”. Merrill Lynch has recently announced plans to open the first foreign investment bank in Turkey. Foreign interest is expected to be directed at the state banks as well. Following its Letter of Intent to the IMF, the government committed itself to the privatisation of three state banks, Vakif, Halk and Ziraat. Significant progress by these banks has been made in developing a commercial franchise.

The privatisation of state-owned banks started in November 2005 when Vakif. Bank’s IPO raised $1.3bn - almost two-thirds from foreign institutional investors - making it one of the largest listings in the emerging markets banking sector in 2005. The two remaining state banks will follow with a 30-40% stake in Halk to be sold via public offering in 2006 and Ziraat’s privatisation is scheduled to start in 2007 or early 2008.

Since the establishment of the Istanbul Stock Exchange (ISE) in 1986, capital markets have made considerable progress despite long standing macro-economic imbalances and the overwhelming dominance of the public sector.

With macroeconomic indicators demonstrating significant evolution, both primary and secondary markets have improved performance every year following the 2001 financial crisis. The value of the ISE National 100 Index rose almost fourfold between December 2002-April 2006 from 10,369 to 45,353. The May 2006 hiccup, however, caused the index to regress to a level of 33,000 (see Market Volatility article). The market capitalisation for all the companies listed on the ISE went up from $33.8bn at the end of 2002 to $139bn today. The capitalisation rate is considered low at about 30% of GDP. The volatility of the ISE is largely caused by a lack of local institutional investors. The recent establishment of private pension funds may reduce volatility in the long-term (see Pension funds article). The first pension contract came into effect in October 2003.

The average daily turnover in the ISE equities market was $794m and the total trading volume was $201.8bn in 2005. As of 2006, daily turnover is at $1,096m. Since the mid-May shake-up in the economy the daily average dropped to 2005 levels in June and July. The overall 2006 figure indicates a 38% increase over the previous year.

The ISE comprises the National Market, the Second National Market, New Economy Market and the Watch List Companies Market. The number of corporations with shares traded on the ISE equities market was 80 in 1986 when the ISE was first established. As of the end of 2005, there were 282 corporations traded on the national market, 16 corporations on the second national market, two on the new economy market and four on the watch list market, making a total of 304.

Capital markets lack depth and diversity due to low investment levels in production activities from the financial services industry. Further hindering the capital markets’ improvement are: high public sector borrowing requirements, high rates of real interest paid on government debt securities and high inflation rates. These factors have diminished the funds available to the private sector.

Equities and mutual fund participation certificates make up most of the outstanding private sector securities. Naturally, during high inflation periods, more flexible and sophisticated financial instruments were difficult to introduce. Furthermore, not all large Turkish companies are publicly traded as most of them still retain a family structure.

Typically, when going public only about a quarter of the equity is floated by these firms. This raises certain questions concerning corporate governance among investors (see Corporate Governance article). Additionally, the corporate bond market is almost non-existent though there are plans to develop such longer term debt instruments in the coming years.

The capital markets have gone through a string of recent developments. The Capital Markets Boards (CMB) finalised the harmonisation of the International Financial Reporting Standards in 2003. All firms listed on the exchange as well as all brokerage houses and portfolio management firms were obliged to adopt these standards at the start of 2005.

Future prospects look rosy with constant GDP growth and the consequent growth of total banking assets. With product diversification, technological infrastructure and international transactions expertise in place, what the Turkish banking sector needs at this stage is cooperation with globally competitive international institutions. Observing the intensifying competition between western and Middle Eastern banks, Ahmet Erelcin, managing director of HSBC Investments claims that “Turkey is the last frontier on which international banks are fighting”. Citibank as well as the Dubai Islamic Bank see Turkey as a strategic investment destination. Such developments are bound to push already high bank prices even higher.

For the first time in decades, Turkey has had to prepare itself for a new scenario, a single digit inflation environment. To remain competitive, the Turkish financial sector has to amend its current agenda and review its strategy.

Compared to the EU, product and channel distribution levels are low, signifying that the banking sector has great potential in terms scale and depth. According to the Banks Association of Turkey, the ratio of total assets to GNP is 82%, compared to over 450% in the EU.

Turkish banks tripled their value in the past year and are expected to grow steadily in the coming years. Berrin Onder, GM of AK Securities forecasts that the banking sector will grow at an average of approximately 8% per year until 2010. She believes that “the asset size will eclipse $350bn by 2010 and could be around $800bn by 2020, while the ratio of total assets to GDP will hover around 90% in 2010 and surpass 110% by 2020.”

Ates adds that, in the midst of a busy M&A environment, decelerating inflation and falling interest rates will lead to a rationalisation of the banking sector. Small banks will be forced to merge, specialise or disappear, while large private banks, which have a real customer franchise, sophisticated IT systems, and good management should survive and thrive. Along with macroeconomic stability, financial reforms and continued privatization efforts, foreign presence seems destined to increase in the future.

Intermediation costs are still high but as Rodrigo de Rato of the IMF stated, “The Turkish government intends to simplify corporate and personal income taxes, phase out financial intermediation taxes and harmonise the tax treatment of financial instruments.” The intermediation tax is due to be phased out by May 2007. Early in July 2006, President Ahmet Necdet Sezer ratified a law scrapping the withholding tax for foreigners on capital gains from shares and bonds.

According to Handan Saygin, investor relations senior VP at Garanti Bank, banks will become more competitive and advanced. They will start focusing more on real banking activities such as consumer credits, SME loans and credit cards rather than government securities.

As Turkey develops, wealth, consumer spending and savings are bound to increase. This will naturally translate into a demand for more sophisticated financial products. Headquartered in Izmir, the Turkish Derivatives Exchange (TurkDEX), Turkey’s first and only futures and derivatives exchange, opened its doors in early 2005.

Additionally, with social security reform under debate in parliament, the insurance and pension fund market will grow rapidly, creating a demand for long-term financial products. Fikret Comert, director of institutional investor relations at Sabanci Holding, believes that taking into account the recent hiccup, the progress achieved in the macroeconomic environment will continue to fuel the capital markets and “long-term plans will not change”.

Furthermore, EU-inspired corporate governance and financial market regulation will lead to the development of a more liquid and deeper equity market. As the sector becomes more transparent, foreign investors will consider alternative investment options such as the relatively young private equity market.

As Osman Birsen, chairman and CEO of the Istanbul Stock Exchange, reminds: “Don’t be late”.