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Do Turkey’s Rewards Justify its Risks?

The country looks more attractive outside the EU than within. But its current account deficit is too large by emerging-markets standards.

Turkey (the country, not the bird about to be consumed at so many U.S. holiday dinner tables) provides an excellent modern example of the old dictum that it is better to travel hopefully than to arrive.

Since the 1980s the country has introduced a slew of economic reforms, designed in part to meet its long-term goal of achieving membership of the EU, whose member states insist on a clean economic bill of health as a condition of entry.

These reforms, including the elimination of most government subsidies and the opening of the country to foreign direct investment, have formed the bedrock that has allowed the economy to thrive — with a gross domestic product (GDP) growth rate of 9.2 percent in 2010 that was the highest in Europe. Growth has slowed this year to a projected 3 percent, but is expected by economists to accelerate again in the coming years.

A clean economic bill is not enough, however, given political barriers such as Turkey’s refusal to recognize EU member Cyprus. Turkey’s chances of EU entry now look uncertain at best, but the legacy of its EU ambitions remains: Many analysts say the economy is well-placed to achieve continuing strong economic growth, thanks to past and present reforms. Ironically, if Turkey had managed to join the union and enter the metaphorical heart of Europe, it might by now be a member of the euro zone’s troubled periphery, suffering from the effects of the boom-to-bust trajectory that hit other high-growth economies.

Reality is much sunnier than this gloomy "what if?" scenario. This month Fitch upgraded Turkish sovereign debt to investment-grade, at a time when many euro zone countries are still nervously on guard for the opposite — particularly after Moody’s Investors Service stripped France of its triple-A rating on Tuesday.

“The Turkish stock market has become more attractive because of its much improved macroeconomic stability, large domestic market and young demographics, which leaves it without the fiscal burden faced by other countries with greyer populations,” says Thomas Leventhorpe, client portfolio manager at J.P. Morgan Asset Management in New York. He also cites attempts by the government to correct imbalances in the economy. Turkey has a population of 75 million — making it Europe’s third-largest nation after Russia and Germany.

Reflecting the sunny optimism of many investors, the Istanbul Stock Exchange National 100 index is up 38.1 percent in the year to date — though this vote of confidence has also eroded its valuation advantage relative to other emerging markets. Turkish equities are trading at around ten times consensus forward-earnings according to J.P. Morgan Asset Management — similar to the emerging world as a whole.

The government may be working prudently at addressing imbalances, but institutional investors would prefer it, naturally, if there were no significant imbalances that needed prudent management in the first place. Foremost among these is a gaping current account deficit of 7.5 percent of GDP — far above the 5 percent, which many emerging-markets economists regard as marking the rough dividing line between safety and unsustainability.

Bringing down the current account deficit presents the Turkish government with a tricky conundrum. At its root is high domestic consumption, which keeps import volumes much higher than export volumes. Exports would rise if the value of the Turkish lira was reduced through lower interest rates. However, lira depreciation could provoke a stampede for the exits among foreign investors — creating a funding gap and a financial crisis for Turkey. In lunchtime European trading on Wednesday there were 2.3 lira to the euro — leaving the currency overvalued and vulnerable, according to many analysts.

However, Leventhorpe thinks the government is taking steps in the right direction to reduce the current account deficit — dampening consumption through tax incentives to encourage long-term saving, for example. “Boosting domestic private saving is something which the government is clearly focused on,” he says, while acknowledging that such steps will take a while to leave a positive imprint on the country’s low savings rate, which has dipped to a 30-year low of 13 percent of GDP.

Despite these reforms aimed at ironing out the imbalances of the Turkish economy, some analysts are wary of putting money in the country. “I would not invest in Turkish equities right now,” says Ed Lalanne, senior strategist at Macro Risk Advisors in New York. “The governments of Russia or Iran have played a crucial role in funding Turkey’s current account deficit by encouraging their banks to buy much of its bank debt. If either country decides it wants to get out of Turkey because Turkey is not doing what it wants, there would quickly be a currency, economic and banking crisis, which would be terrible for all Turkish assets including equities.”

Turkish equities remain, therefore, one of the world’s riskier investment propositions, but with opportunities for earnings growth in their home markets that are beyond the wildest dreams of listed euro zone companies.

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