Q2 Recap: Economy Regaining Momentum

Turkish economy has appeared to be regaining momentum and followed the path of recovery after a dismal record in the second half of last year. After 1Q17 when Turkey posted a growth rate that exceeded expectations, economic indicator overall suggested the continuation of the economic upswing and we now estimate that Turkey will post another 5% growth rate for second quarter.

Before leading in, we see it fit to add some comments about Turkey’s GDP revision. We believe that the harsh criticism over the reliance of the this new methodology on current prices is justified, as well as huge back dated revisions make rationalizing the data even harder. To date we have seen some examples of some poor countries turning into middle class ones overnight (Ghana in 2013, Nigeria 2014). Being skeptical of accuracy of economic data in developing economies is likely to be a rising phenomenon across the board where not just the future but also the past starts to become uncertain.

Turning back to the subject at hand, yesterday’s industrial production data suggested an average increase of 1.2% in the 3-month period ended in May, but more importantly, capital goods, that performed a 3.6% growth in the same regard gave us the color we needed to draw a rosy picture. The overall trend in both indicators showed an uptick that could be a sign of a better shape in the economy in months to come.

On another positive note, we still see export to be contribution to output growth in Turkey as our bullish scenario for auto production (exports) is still intact due to depreciated lira and the recovery in Europe.

After such optimistic comments, this is where we should note that there are plenty of reasons to feel unsettled about this economic growth since we see the government sponsored lending growth as the main driver of it. Turkey’s banks experienced one of the fastest lending booms in country’s financial history in February-April period. While this increases chance of major asset quality deterioration in case of an economic downturn, it sets the bar high for growth due to the base effect. Turkey may find itself in a scuzzy situation after this impermanent business cycle.

Mortgage Boom in the Making

Construction sector has maintained a significant role for Turkish economy in recent years as house prices in mega cities have skyrocketed and government sponsored large projects have been under way. Now with the economy sending signals of slowdown, we not surprisingly saw some attempts to boost the industry which has been at the forefront of the country’s recent economic development. Other than transforming the skyline of Istanbul, ─admittedly not many residents of the city take a fancy to this─ this may have some unexpected and unintended implications for the economy.

Not to mention the bubble it has created and possibility of economy toppled once it bursts, we currently observe strange findings in the financial space. First, Turkish central bank has increased its average cost of funding rate, in other words the effective rate, via some unconventional methods such as acting solely as a lender of last resort rather than a central bank. Meanwhile, mortgage rates have kept falling like dead leaves and now the average rate for the mortgage production is lower than the effective rate the central bank implied, which means Turkish banks provide mortgage loans at a loss. While banks are able to offset the loss via some fees and cross selling activities, we see it as long-term risk as rates are set to be higher in the upcoming period that would leave lenders with significant interest rate and liquidity risks. Please note that banks in Turkey are still not comfortable with the funding side.

So, the question may arise as to which segment of the banking records high origination activity recently. It comes as no surprise that state-run banks again take the lead in mortgage market and outperforming the rest of the industry by a wide margin.

With naysayers in the banking community now having the upper hand across the board, one would imagine the conservative and high quality underwriting standards and solid risk management in Turkish banks where regulations have been extremely strict but functioning well, but not, likely as a part of the ongoing “structural deform” process.

Time for A Macro Update

It is time for an update after a hiatus of several weeks on the blog. In our previous two articles, we put emphasis on Q3 GDP growth which posted a bad reading as the economic output growth turned to negative territory for the first time since the aftermath of the late-2008 global financial crisis, and the rising unemployment figures on the back of the weaker services sector. Below we provide a summary of the latest economic development to keep our readers updated.

Growth Outlook

The data set of industrial production index has just completed with the release of December data which provided mixed signals for the outlook of the economy. Overall, we believe that some industries such as auto production are still strong and remarkably contribute to the output growth while the rest of the economy is facing severe challenges. As visualized at the following chart, 12-month moving average of the Industrial Production Index suggests a halting economic growth. That said, we expect Q4 GDP growth to be around 1.5% which would mean a return to growth but with a relatively weaker recovery.

Inflation Back to Double-Digit Numbers

Back in November we noted that we expected core inflation to hit 8.5% in 1H17. As we start the new year, we foresee that our target is likely to be overshot. Even worse, we are very likely to see headline inflation going above 11% in March owing to the base effect impact. The chart above demonstrates the evolution of headline inflation and some other core indicators. Meanwhile, Turkish central bank, standing at the peak of monetary policy unorthodoxy, engineered to a de facto rate hike of 200 bps, taking the effective funding rate at 10.3% in an attempt to support the local currency.

Going forward, on the macro front we believe the upcoming referendum will be the overriding theme, as the political risks remain severe. We also see the newly introduced sovereign wealth fund adding to the risk premium due to uncertainties around its management and decreasing cash flows into the government budget due to the lack of dividend payment from the companies to transferred to the Fund.