LONDON Nov 21 Be careful what you wish for.
Turkey's long-awaited restoration to investment grade has
the potential to turn into a policy headache for authorities
trying to prevent foreign capital from inflating the lira's
The sovereign was upgraded by Fitch Ratings earlier this
month after being classed as a speculative buy for 18 years. If
Moody's also elevates the country to the lower-risk ratings
category as expected, its debt will be eligible for inclusion in
mainstream global bond indices - setting the stage for big-money
investment funds to take a slice.
New financial market inflows, estimated in the billions of
dollars, will provide valuable financing for Turkey's huge
balance of payments deficit and help cut borrowing costs for
companies and government.
But there is a downside. Billions of dollars of additional
investment flows and a stronger lira could render Turkish
exports less competitive in a slowing world economy where demand
is scarce and competition fierce.
"This is a nice headache to have but it is a very big
headache too," says Murat Toprak, a currency strategist at HSBC.
"The way the central bank looks at it is: investment-grade
may lead to lower borrowing costs, but the first stage is
capital inflows and currency appreciation, and that will cause
Moody's said on Tuesday it had kept Turkey's rating at Ba1,
one notch below investment grade, after an annual review, but
reaffirmed its positive outlook on the country.
JP Morgan estimates foreigners have already bought almost $1
billion worth of Turkish lira bonds this month, driving two-year
yields down nearly a percentage point to record lows.
Even before Fitch's November 5 upgrade, foreign funds
encouraged by central bank successes this year in taming
inflation and the balance of payments gap had pumped $13.6
billion into local bonds, according to central bank data.
Equities too had drawn in almost $5 billion by end-October,
making the Istanbul index one of the best performers of 2012
with dollar-based returns of almost 50 percent.
The central bank will be less pleased with a JP Morgan
client survey that found fund managers have boosted their
overweight positions on the lira to record highs. That reflects
an implied yield of almost 5 percent on the currency over the
next year, among the highest in emerging markets.
"The lira is one of the currencies you want to have longs on
in a sustained manner," says Jeremy Brewin, a fund manager at
Aviva Investors who is overweight Turkish bonds and lira.
But some disappointment may lie ahead. The central bank has
swung firmly away from its lira-supportive stance of early this
year and is now focusing on weakening the currency by reducing
its appeal to foreigners.
On Tuesday, it slashed overnight lending rates, used to
supply cash to the market, for the third month running, even
though inflation is well above target. It also warned it would
cut the main policy rate and the borrowing rate if needed - a
powerful signal to any lira bulls.
"You can buy Turkish assets but don't bet on currency
appreciation to increase your returns," HSBC's Toprak said.
The central bank has reason for alarm. The lira has risen 4
percent against the dollar this year, while in real terms -
versus currencies of trade partners and adjusted for inflation -
it has appreciated more than 7 percent.
"The Turkish economy is struggling for competitiveness,"
said Manik Narain, a strategist at UBS, noting that a 15 percent
annual rise in exports was largely down to gold sales to the
Middle East, with exports elsewhere largely flat.
Linked to this is worry over Turkey's current account
deficit, which at 7 percent of economic output is among the
world's highest, leaving the country vulnerable to the ebb and
flow of global capital.
While portfolio investments are helping to fill this gap, a
stronger lira has the potential to blow it out again to the
10-percent-plus levels of 2011, by reigniting credit growth and
demand for imported goods.
Aviva's Brewin reckons that with Moody's also likely to move
Turkey's rating out of junk territory, lira bets can only grow.
"They will have to get short-term rates down very low to
deter people who think the credit rating is going to improve,"
Foreigners currently hold roughly 20 percent of Turkey's
bond market compared with 30-40 percent for investment grade
peers such as Poland, South Africa and Mexico.
Barclays says a Moody's upgrade would make Turkish hard
currency bonds eligible for its flagship Global Aggregate bond
index, which is tracked by funds managing $6.5 trillion.
Assuming an index weight of 0.14 percent, Turkish Eurobonds
could attract $2.0-$2.5 billion in new money, analysts at the
bank reckon - considerably more than Turkey is expected to issue
in global bond markets next year in net terms.
If lira bonds eventually enter the index, Barclays predicts
up to $2.5 billion in new demand for domestic debt, lifting
foreigners' share of the local market to 22 percent.
Turkish broker Oyak Securities is even more optimistic,
suggesting an additional $100 billion in cumulative funding over
the next 10 years.
There are lessons, however, for Turkey from emerging peer
Indonesia, which became investment-grade in early 2012. Foreign
holdings of Indonesian bonds reached a peak of more than 35
percent but have since fallen to under 30 percent as the rupiah
has weakened and concern has grown over economic policies.
Further Turkish interest rate cuts may also soon become
untenable, Goldman Sachs analysts said, adding that the central
bank's dovish stance will "ultimately be undermined by large
external imbalances and high and sticky inflation".