Executive Summary

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After impressive real GNP growth of 7.7% in H106 - marginally higher than the 7.6% registered in 2005 - the economy slowed dramatically in Q3 to 3.0% y-o-y, following a collapse of private sector spending and, to a lesser extent, investment, in the wake of the lira's sharp decline in May and June. With the lira now back to within 5% of pre-May levels and energy prices having fallen around US$20/bbl from their mid-2006 highs, the inflationary impact of the lira's decline is waning. Assuming that a new lira sell-off does not occur, we believe that the economy will recover from early-2007, returning to its trend rate of around 5% over the remainder of the forecast period. Given Turkey's balance of payments profile, however, the country remains highly vulnerable to a new outflow of foreign capital. Consequently, we expect the volatility of Turkey's growth - a key danger to investors - to remain high over the medium term.

Fall In GNP Growth: Volatile But Worst Over
While BMI had anticipated a deceleration, real GNP growth fell to 3.0% year-on-year (y-o-y) in Q306, its lowest rate since Q102, and a sharp slowdown from the 8.8% y-o-y expansion registered in Q206. Furthermore, domestic demand growth was a paltry 1.3% y-o-y, with expansion of private consumption - previously the bulwark of the economy - collapsing from 10.4% y-o-y in Q2 to 1.3% y-o-y. Indeed, it was the external sector, previously the economy's weakness, which underpinned growth, with net exports contributing 1.66 percentage points to the 3% expansion owing to strong export expansion due to the competitive boost provided by the lira's decline.

The key question, however, is how long the slowdown will last. Latest economic data suggests that the worst may be over, but that a rapid recovery has not yet begun. After hitting bottom at 148.37 in October, the CBT's leading indicator had risen marginally to 149.29 in December, while the consumer confidence index was 92.0 in December, more or less unchanged since August, but at least off its lows. However, tangible shoots of recovery are hard to find. Growth of loans and credit card borrowing fell to 42.9% y-oy on February 2, down from around 75% y-o-y, where it had stabilised between June 2005 and June 2006. Also, import volumes - which correlate with both currency movements and domestic demand - remained weak in December, with a 10.9% y-o-y fall in capital goods.

After stabilising in H107, we expect growth to strengthen in H207 and to broadly maintain 5% average growth over the medium term. Within this, high capital flows will underpin the lira, pressuring exports and leaving domestic demand responsible for driving growth. At the same time, with government spending expansion likely to be constrained by the IMF-approved reform programme, we anticipate that private sector spending and investment 0150 the latter of which will be boosted by inflows of FDI – will be responsible for the sustainability of the expansion.

The Commercial Banking Sector
Loan growth, fuelled by low interest rates, is promoting the boom currently being witnessed by the Turkish commercial banking sector. By both Central and Eastern European (CEE) and Middle Eastern standards, the growth of Turkey’s banks in assets, loans, and deposits has been significant, most recent figures showing growth rates of 38%, 21%, and 22% (local currency terms). Of the 59 countries (worldwide) that BMI has collated data for, these growth rates are ranked at 20th, 10th and 20th respectively.

While the Turkish sector is large by both CEE and Middle Eastern standards, it nonetheless remains underdeveloped, especially given the low loan/deposit and loan/asset ratios, which indicate that very strong loan growth could easily be funded by Turkish banks. Out of BMI’s 59 country sample, Turkey’s loan/deposit, loan/asset and loan/GDP ratios were ranked very lowly at 51st, 48th and 46th respectively – the ratios were 60.3%, 39.4% and 30.9%. All three have risen since December 2006.

Latest figures indicate that Turkish banks hold approximately US$61.6bn in bonds, with y-o-y growth of 10%. The banks’ bond holdings amount to about 23.1% of total assets. BMI considers that in an international context, Turkish banks are highly exposed to bonds.

The key risk to the Turkish commercial banking sector appears to be macroeconomic in nature; more specifically, a crisis of investor confidence could result in currency volatility and foreign investment moving out of Turkey. Foreign investment has been important in funding Turkey’s large current account deficit.

Press Reports
Recent reports in the Turkish and international press generally reflect two main issues. First is foreign investment from banks. A new willingness among Turkey's biggest business families to shed their banking assets has contributed to a foreign-investment inflow. Foreign banks are pouring into Turkey, spending billions to acquire stakes in local banks despite political unrest, EU uncertainty and complaints of unfair treatment for foreign investors in Turkey’s courts. This is attributed to the fact that Turkey is considered "underbanked" for its rapidly growing economy of 72mn people, more than half of whom are under 21 years old. Turkey is currently considered “one of the most attractive markets, alongside places such as China and Malaysia," says Yvan De Cock, the chief executive for Turkey for Dutch-Belgian bank and insurance company Fortis.

The second key issue, and good news for the Turkish business sector, is that Turkish banks are all reporting profits. This is perhaps as a result of foreign investment on top of restructuring and consolidation of the banking sector. However, economic stability will only arise from political stability and investment. With external investment flowing, it appears that political unrest may be a large contributor to Turkey’s only moderate growth.