AN INVESTMENT-GRADE STORY
Moderated by Dan Keeler
Global Finance hosted Turkey’s central bank governor and Turkish financial executives at a roundtable in Istanbul in September to discuss economic development, the importance of Turkey’s upgrade to investment grade and the strength of the country’s financial sector.
Global Finance : Two years ago Turkey’s central bank adopted a somewhat unorthodox approach to tackling the then-widespread economic and financial volatility. How does this policy work?
Erdem Ba ş çı, governor of the Central Bank of Turkey: Turkey enjoyed a very strong recovery after the Lehman crisis, with two consecutive years of extremely strong growth and a previously unseen level of credit growth—on the order of 35%. However, we had identified that credit growth, or more specifically the change in credit stock measured as a proportion of GDP, is a key leading indicator for an impending crisis. We also had an overvalued currency, and external factors were making it even worse. With the prospect of more short-term capital inflows, if we had done nothing we would have experienced more currency appreciation and maybe even faster credit growth. We couldn’t use monetary policy because if you tighten monetary policy, the currency will appreciate more. So we kept short-term interest rates as low as possible but tightened via macroprudential tools. One of those—reserve requirements—is at the disposal of the central bank, and all the rest are at the disposal of other agencies in the economy, such as loan-to-value restrictions for housing, risk rates on consumer loans and general provision requirements. Turkey used all of them.
GF : How have those strategies affected the growth and stability of Turkey’s economy?
Ba ş çı : It worked. We were able to engineer a soft landing, together with the rebalancing of demand. Credit growth rates fell first to 25% last year, and they will come close to or even below 15% by the end of this year. The currency story is more complicated. When the eurozone debt crisis hit, we suffered from too much depreciation, which meant we could use monetary tightening. We did that by setting up a wide interest-rate corridor. Essentially we moved from a one-dimensional regimen to a two-dimensional one. We were using this combination of the two dimensions—monetary and macroprudential—while also paying attention to the currency. Now we are very comfortable with the speed of credit growth and with the fact that the currency is floating, mainly under the influence of economic fundamentals.
GF: How is this unorthodox approach affecting the banking sector?
Ba ş çı: It’s been a learning process for the market players as well as the central bank itself, because these are uncharted waters. We have used all the methods that we could under an open capital account without using any capital flow measures. The key is to improve the financial sector resilience and, at the same time, to cope with the adverse impacts of short-term capital flows.
GF : In the early stages the central bank relied heavily on the banking industry to help with the process of stabilization. What has the banks’ experience been in this process?
Faik Açıkalın, CEO of Yapı Kredi: When we were told that the central bank had set a loan-growth target for 2011 of 25% with the aim of controlling the current-account deficit we were somewhat surprised, because we believed the central bank’s goal was price stability. However, the central bank’s explanation was enlightening, because it pointed out that a growing current-account deficit was a threat for economic stability, which is a prerequisite for financial stability. Turkey’s economy necessitates a more agile central bank than many other countries’ and once we understood this, the banks were convinced that this model could work, we got used to the new conditions, and we are cooperating.
Alp Keler, CEO, Ak Asset Management: The euro crisis last year affected the success of the program in the second half of the year. But this year, global conditions have supported the central bank’s policy and the dual-interest-rate policy increased the central bank’s flexibility. Under the new policy, through adjusting the interest rates, the central bank is able to respond more quickly to signs of economic slowdown or faster-than-expected loan growth. Also, it has improved the stability of the Turkish lira against other currencies. The strategy is working, and Turkey is in a much more stable condition.
Alp Sivrio ğ lu, CFO, ING Bank Turkey: The central bank clearly explained the linkage between loan growth and the current-account deficit and the need for the interest rate corridor, but it is not easy for us to operate when we don’t know what interest rates will be from day to day. However, we all understand the policy, and it worked very well—we all believe that if it works for the economy in the longer term, it will also help the financial services sector.
Metin Ar, CEO, Garanti Securities: Overall, the policies implemented by the central bank in coordination with other government agencies over the past two years have been successful in restoring financial stability and also narrowing the current-account deficit. The dual-interest-rate policy has been a successful innovation and has been effective in dictating loan pricing.
Samir Hanna, group CEO, Bank Audi: Communication from the central bank helps, so the banks are not being surprised by a move and not understanding what’s behind it.
GF : Interest rates have come down from historic highs in Turkey. How are companies in Turkey’s financial sector adapting to this new interest rate environment?
Sivrio ğ lu: Turkey’s banks have been operating with sizable free capital since the sector’s 2001 restructuring, but the gains they generated from their capital when policy rates were around 17% will not be there any more. Now policy rates are closer to 6%. That will make the banks more eager to grow to generate profit.
Ba ş çı: The Turkish banking market is intensely competitive, and in the post-Lehman recovery the spreads between loans and deposits shrank to unseen levels. Only if you grow very fast can you live with such narrow interest margins. Now, though, after all these policy actions, interest margins are at or maybe above 500 basis points, which means you can live with slow credit growth.
Açıkalın : With less borrowing by the Treasury there has been a substantial change in the balance sheet composition of the financial system, with government securities representing a smaller proportion of total assets. The banks have had to choose what to do with the liquidity from the government securities. The changes in the balance of financial assets open a new opportunity not only for the banks but also for companies through the corporate bond markets. Two years ago the value of the corporate bonds issued was almost nil. Now it’s become a significant percentage of the market.
Keler: The financial sector is becoming much more aggressive because they [banks] have to compete. As a result, the banks started to look for new tools for funding and corporate bond markets started to develop. This is important for us as an institutional investor because it means there is another product we can invest in.
Ar: As a result of the stability and also as a result of the new legislation issued by the capital markets board, the banks have started tapping another channel, which is the capital markets, to finance some of their Turkish lira requirements.
Sivrio ğ lu: The most important thing we have to do is to create an environment for the Turkish banking system to generate its own profitability to feed the future growth—without additional capital injection needs. With the current environment, the banking sector needs to grow faster because we can no longer benefit from significant capital gains, but the decisions on how we should grow and what leverage is acceptable should be based on a cautious, balanced debate between the banks and the regulators.
Hanna: Running costs are important, too. At the current 2.75% of the total assets, they are very high. There has to be more efficiency in the system, and it is really up to the banks to reduce this to, say, less than 2% if not 1.5%.
GF: What can the central bank do to support the Turkish economy?
Ba ş çı: The Turkish economy does not need any monetary stimulus to grow. Just pulling our foot from the brake a little will be enough to spur domestic demand growth. That is exactly what the central bank is doing.
Açıkalın: The most important contribution the central bank can make is the low-interest-rate environment, which is supporting macroeconomic growth, which will lead to a higher disposable income. The lack of domestic savings is one of the major problems we face, and once there is more stability, people will be more likely to save.
Sivrio ğ lu: Encouraging saving—and especially lengthening the maturity of savings—is not easy for Turkey because of the historical bad memories of inflation. However, the banking sector is now much more dependent on retail funding, because it is the safest funding source for the local banks. In a crisis situation, you cannot rely on funding from professional markets such as bond markets.
Keler: Saving is a cultural issue in Turkey. When people think about investments, first they think about gold, then real estate then time deposits. But they’re starting to look for alternatives. If the mutual funds and the institutional investors can grow faster during this period, it will help to develop a savings culture in Turkey.
GF : How is the flux in capital markets legislation affecting the banking sector?
Ar: There is an effort to separate investment banking from commercial banking as much as possible, but since all the banks have subsidiaries like us, they will shift some of the products or some of the requirements to the subsidiaries, so the impact on the banks will be limited.
Açıkalın: Turkey’s banks are not as leveraged as the Western banks that suffered in the recent crisis, and our investment securities companies are 100% consolidated under the bank’s balance sheet. It’s not the structures that are most important, it is the mentality, and Turkish banks have already proved, during the crisis, that they are prudent.
Sivrio ğ lu: In Turkey the subsidiaries of the banks involved in the capital markets are pretty much controlled by the Capital Markets Board. And because the banks are consolidated, the activities of their subsidiaries are controlled and supervised by the banking authority. And the banks’ risk departments also oversee their subsidiaries’ risks. The Turkish banking sector is already prudent, compared to its peers in Europe or the States, and well supervised and regulated.
Keler: The capital markets are currently small, compared to the banking sector. In order for Istanbul to become a financial center, Turkey’s financial institutions must be strong in all areas, which is why the Capital Markets Board is looking at this. The new capital markets law brings several changes in the securities and the asset management areas, which will help the financial sector grow faster.
GF: What role is private equity playing in Turkey’s economic development?
Ar: Private equity exposure in Turkey has been very limited. However, of the total historical cumulative amount of $15 billion that has been invested through private equity, $14.7 billion was invested in the past six years. Private equity players are all international—there’s probably not a single dollar coming from Turkey. The amount has grown sharply, but it is minimal compared to European and US standards. There is, though, new legislation that should be very effective in promoting private equity, so we expect to see new money coming in, particularly in the consumer-facing sectors.
Keler: There is a strong need for alternative sources of investment, so we are pleased with this recent legislation, which should help private equity investors take higher positions in Turkey. Turkey offers great opportunities for these investors.
GF : How will Turkey’s upgrade by ratings agency Fitch to investment grade affect the economy?
Açıkalın: It should help attract more foreign direct investment. Sovereign rates should come down, lowering borrowing rates for institutions and companies. This will help equity markets grow, boost economic activity and make long-term growth more sustainable as the depth of the market increases. For some investors, investment grade is a precondition to come to the country, so you could see a surge in investment.
Açıkalın: Banks will have improved access to lower-cost and longer-term foreign financing. Local funding costs are also expected to decline in parallel to this. It could cause a surge in inward investment, though, and in this case we might see pressure on the current-account deficit. The central bank might use tools such as reserve requirement ratios to prevent excessive capital flows and currency appreciation.
Ba ş çı: We could have quite a rise in portfolio flows, and that could put appreciation pressure on the currency, but we are better prepared to cope with such a change compared to, say, three years ago.
GF: Is there a sense that foreign investors are already seeing Turkey as investment-grade?
Hanna: It took me only 15 minutes to convince the governor of the Lebanese central bank to consider Turkey as investment-grade. Turkey’s recent economic achievements on the back of structural changes bear witness to the robustness of its national economy and to its remarkable capacity to build on its domestic strengths and adapt to a challenging external environment. I strongly believe that Turkey will achieve full investment-grade status sooner rather than later.
Sivrio ğ lu: To an extent, the market has already priced in the investment-grade story so I don’t think there will be a sharp decrease in interest rates. However, the appetite for the banking sector from foreign players will increase because, once the country is investment-grade, exposure to assets in this country will no longer be 100% risk-rated. That will have a positive impact in the financial sector.
Hanna: Turkey’s recent sukuk issue was six times oversubscribed. But for loans, for paper, for bonds, if it goes to people who know Turkey or are ready to listen to the Turkish story, definitely there is plenty of potential.
Ar: For mutual funds and some private banking money, becoming investment-grade is very relevant and important. The moment we have investment-grade status from two of the agencies, we will have an influx of funds. On the FDI side, though, it is less relevant. What is more relevant is that the appetite of investors from Europe and the US has decreased, mainly because of the problems in their own backyard.
Keler: In the CDS [credit default swap] and eurobond markets, Turkey is already treated as an investment-grade country and equities have already seen flows from foreign investors who are taking positions in anticipation of a potential upgrade. However, this upgrade will still pave the way for some foreign pension and mutual funds that cannot invest in non-investment-grade instruments. Additionally, Turkey’s share in the MSCI index will increase, which is another reason for Turkish markets to attract more capital in the near future.
GF : What are the main challenges facing Turkey’s banks?
Sivrio ğ lu: In this new low-interest-rate environment, finding ways to cheapen your cost of funding on the liability side will be critical. Although the upper band of the interest rate corridor has already been lowered, the decrease will probably not be reflected quickly in lending prices. There is a risk that all the banks may tend to increase their exposure more in riskier segments in order to focus more on spreads.
Açıkalın: The challenge in the medium-to-long run will be finding the capital to fuel growth and profitability. We are lagging on the deposit side, compared to loan growth, especially in local-currency deposits, which is causing an imbalance. As a result, funding diversification will be a critical priority for the very near future for all Turkish banks. Another challenge is asset quality. When interest rates are high, it’s easier to digest problem loans, but when you are dealing with 5% interest rates, it takes much longer. Last but not least is the challenge of sustaining profitability.
Hanna: Unless a bank has a critical mass in terms of non-interest income it will be hard to ensure an acceptable return on equity. With the low interest rates, that is something that is on our minds right now as we try to build market share. We don’t really have room to breathe now.
Sivrio ğ lu: There may be a need for some consolidation. As of mid-2012, 12 banks, including state banks, make up around 85% of the total banking sector. After consolidation, we could end up with five or six giant banks, but then the question becomes, what is the best model for our country?
Açıkalın: In terms of productivity and efficiency, bank-wide economy of scale is only one part of the story. There is some room for us to cooperate with our competitors. We’re investing in building our networks and services, and at the end of today they can easily be shared, creating an industry-wide economy of scale.