External Debt – Turkish Market News

Pakistan: An Attractive Frontier Market Pick in Asia

Macroeconomic Outlook

After years of full of challenges, Pakistani economy is now out of the woods with high-single digit GDP growth rates projected for the upcoming two years. Even if the country still faces some significant political risks and has some vulnerabilities due to high indebtedness, we believe the provided risk-reward profile is very compelling at this point.

Pakistan is one of the few frontier markets that are expected to receive a credit rating upgrade this year. As of now the country is rated as B-by Standard & Poor’s with positive outlook with opportunities and risks recognized.

This year is crucially important for Pakistani economy as about 40% of the country’s outstanding debt, which amounts to $45 billion, is due to mature in 2016, of that $41 billion is in local currency. However, we believe that existing IMF funding and the Chinese investment in an economic corridor will offset the pressure as we see no reason to panic for the outlook of the economy.

The government embarked on a number of reforms, many under the aegis of an Extended Fund Facility (EFF) arrangement with the IMF, which included strengthening the State Bank of Pakistan (SBP, the central bank) autonomy through an establishment of an independent monetary policy council for rate setting. Following that, an interest rate corridor was introduced with a ceiling rate of 6.5% and the floor rate of 4.5%. Given the core inflation prints in 3-3.5% range and Pakistani Rupee trading in the narrow range of 104-105 for the past year, the improved monetary transmission mechanism has been successful to stabilize the economic indicators, which will lead a less hazy economic outlook and lower fundamentals risks.

Secondly, The China Pakistan Economic Corridor (CPEC) is a $46 billion FDI pledge from China which will serve as a catalyst for increased economic growth as well as risen geopolitical interest from other countries. Some other counties including Russia, the UAE already announced billion dollar mega projects. Eventually, we will be able to see infrastructure developments needed to boost the economic growth in the long-term which the country has lacked for years.

At the end of 2015 total public debt to GDP ratio stood at 61.5%, showing an improvement of 20 basis points y/y. Meanwhile, total external debt and liabilities rose to 7,2 trillion rupees which amounted to 23.4% of GDP. Having improved its risk profile, Pakistan could have managed to lower its borrowing costs from global financial markets. Moreover, in domestic credit markets, we saw the average rate for outstanding loans in Pakistani banking system coming down to 8.58% in February 2016 from 10.59% in the same month of 2015, while outstanding rates for deposits lowered to 5.03% from 6.7% within the same timeframe. Thanks to the stabilized inflation rates and the new monetary policy framework, we foresee the continuation of the benign trend in the credit markets.

Equities

Founded on September 18, 1947 in Karachi, the largest city of Pakistan, Karachi Stock Exchange has more than 650 companies listed with total market capitalization of $72 billion. It ranked third in 2014 amongst the top ten best performing markets in the world according to analysis by Bloomberg. Our views on specific sectors are as given by.

As discussed above, the ongoing trends in credit markets are in favor or banks. Not surprisingly, total assets grew by 17% system-wide last year, reaching a record level of 14,143 billion rupees (investments and advances grew by 30% and 8%, respectively). In such a growth period, NPLs only totaled 11.4% of total loans (12.3% in 2014). Moreover, Pakistani banks built provision that covered 85% of total NPLs, lowering net NPL ratio to 1.9%. Despite the fact that credit metrics were still not good, banks showed a major development in terms of quality. Commercial banks averagely recorded a ROE of 25.8% when tax excluded up from 24.3% in 2014, as they posted a Tier-1 ratio of 13.1% for full-year 2015, up from 12.9% in 2014. Thanks to increasing profitability and strong capital structures, we are of the opinion that Pakistani banking stocks provide a good environment for not faint-hearted investors looking for opportunities in frontier Asia. The following is our picks from Pakistani stocks.

We believe that Pakistani banking stocks offer attractive value, thus we pick four of the banking stocks with the greatest market cap. Additively, we add an industrial to the list, Lucky Cement, which, we believe, solidifies our portfolio with an outlook for increased spending on construction materials due to the infrastructure deficit and its rarely seen profitability metrics.

The Real Effects of External Debt on Turkey

One basic problem of Turkish economy is that the large current account deficit which is expected to equal to 4.5% of total Gross Domestic Product at the end of this year. When this is the case, the short term capital inflows and foreign direct investments (FDI) in the country becomes crucially important (Recently we published a post about the outlook of FDI in Turkey). That said, short terms capital flows into the country has come into prominence as the volatility in foreign exchange markets rises dramatically pushing Turkish lira to fresh lows, coupled with political pressure on Turkish central bank to lower the interest rates at a time when inflation remains above the official target.

Picking up on short term flows, foreign debt has been a more stable means of finance in the short term provided that domestic savings are remarkably low. This is explaining the Turkey’s heavy dependence on foreign capital inflows into its $800 billion economy. Additionally, foreign exchange reserves of Turkish central bank is known amount to $108.6 which is a figure not enough to fill the gap of short term external debt stocks that was above $130 billion at yearend.

Amid political turbulence and with the largest short term external debt stock ever recorded by its peer group, Turkish lira was expectedly poised to tumble much further. This is a short summary of what happened in foreign exchange markets. Considering the fact that Turkey like any other emerging country will be less able to receive the funds it needs to maintain its economic activities as the United States Federal Reserve pushes the risk aversion button for all markets across the globe with a rate hike, lira will add new fresh lows. But, in this post I mainly touch upon the impact of the short term external debt on economic growth.

According to the data released Turkish central bank, at year-end 2014 the total short term external debt stock of Turkey is $133 billion of which $96 billion comes from Turkish banks’ borrowings, and $36 billion from non-financial private companies. This means a 4% rise in total debt on yearly basis. The rise at year-end 2013 was 35% showing Turkish companies facing difficulties while borrowing from foreign institutions. In order to be clearer, we prepared the chart below that visualizes the annual changes in short term foreign debt stock.

Turkish economy averagely grew 4% between 2006 and 2013, which we accept as a threshold for analyzing Turkish economic growth. As you may guess, red areas in the chart expresses the lower than average growth periods. Specifically in post-global financial crisis period Turkey clearly seems to be growing below its potential unless it posts an annual rise of 20% in short term external debt. This, of course, does not mean that Turkey’s economic growth is completely reliant on borrowing more from foreigners. But somehow two variables correlate perfectly.

The Behavior of Current Account in Turkey

Turkey today posted better than expected current account deficit after naming the deficit as the second most important economic challenge after inflation in its Medium Term Plan. According to the posted official figures the deficit in August was $2.77 billion which is well below the market consensus of $3.2 billion. The country’s deficit for the January-August period also dropped by $16.2 billion to $29.5 billion. Leading economists covering Turkey expect the total deficit to hit $45 billion at year-end that would be approximately %5.7 of country’s total GDP that means a significant drop in country’s deficit but is still above the targeted current account deficit.

Lower than expected deficit is mainly due to sharp increase in services income that hit $6.4 billion in August. Turkey had averagely reported a services income of $5 billion in nine August months between 2005-13. This is suggesting that boosting tourism revenue helped the country to deal with its large deficit.

As discussed many times before the actual amount of the current account deficit is less important than the government’s means of funding it. Here, the Turkish government has been extremely lucky with the global liquidity situation. Unfortunately, Fed’s tightening its monetary policy will start a new turnaround whose balance sheet has been the best Turkish natural source so far. Still no weakness is observed in external funding as banks and companies in Turkey as they are reported collecting $5.1 billion from foreign lenders.

Given the components of income generated in country, it seems hard to narrow the deficit without undermining the fast growth in real consumption (see the chart below). At this stage declining oil prices would be supportive for the economy to grow at the desired pace with no obligation for soft-landing.