Watch Out for Turkey

I believe Turkey is the weak link in the emerging market chain. In this regard, the country could ultimately emerge as the proverbial "bolt out of the blue" that significantly rattles the emerging markets in 2006.

Before exploring the risks, let's give credit where credit is due. Turkey has come a long way since its most recent financial downturn in 2001.

Real growth has accelerated to roughly 5-6% per annum. Inflation, as high as nearly 80% a few years ago, has slowed to an annual pace of 8%.

With the help of the International Monetary Fund and strong capital inflows, macroeconomic stability has been restored, boosting investor confidence.

Indeed, the combination of strong economic growth, low inflation, the start of European Union (EU) accession talks and easy global liquidity conditions has propelled Turkey's primary stock index — the Istanbul Stock Exchange (ISE) 100 Index — into record territory over the past 12 months.

After advancing by 34% in 2004, the main index soared by another 56% in 2005, reaching an all-time high of 47,728.5 in February 2006. Since hitting a cyclical low in October of 2002, the index has soared a staggering 390%.

Over the same period, the Morgan Stanley's broad Emerging Market Index climbed 147%, while the S&P 500 Index gained 68%. That Turkey's stock market remains among the strongest in the world — even after the recent modest correction — is a distinction, in my opinion, that ignores prevailing economic fundamentals.

Instead it reflects easy global liquidity conditions and the risk (read: greed) investors are willing to take on. Over time, the latter variables have tended to burn investors — and Turkey is likely to prove no different.

Even though Turkey still is a darling among foreign investors, we are talking about a country that posted a current account deficit in excess of 6% of GDP in 2005, up from 5.4% in 2004. That's on par with the U.S. savings gap — yet there is a big difference.

While investors may tolerate a current account deficit of this magnitude in a market as deep, liquid and diverse as the United States, investors are rarely as kind to such conditions in an emerging market.

As a benchmark, Turkey's current account deficit averaged 1.1% of GDP over the 1990-2003 period, but has soared recently on account of rising oil prices and decelerating export growth.

Exports have been impaired due to the strength of the Turkish lira, which — by some estimates — is 25-30% overvalued against the dollar and euro.

Rising competition from China has also undercut Turkey's traditional export industries — textiles and clothing. Due in part to China's emergence and rising energy imports from Russia, Turkey's trade deficit widened by 44% in January 2006 versus the year prior.

In addition, one has to consider an unemployment rate officially pegged at 10.4% — but arguably much higher, notably among younger workers.

Next, Turkey's informal (black market) economy could be as large as 50% of the official economic output. Additionally, the country's industrial base is dominated by large, family-owned conglomerates, while small and medium-sized operations remain weak and undercapitalized.

Finally, modest foreign direct investment flows — with cumulative inward investment totaling just $8.6 billion between 2001 and 2004 were less than inflows received by Romania and most of its neighbors in Central Europe.

Granted, investment flows accelerated sharply in 2005 because of privatization proceeds. However, when it comes to bricks and mortar — or so-called "greenfield" investments that entail the construction of new plants and, by extension, new jobs — Turkey has underperformed relative to its peers.

Between 2002 and 2004, for instance, the number of "greenfield" projects in Turkey totaled 179, far less than the number of projects initiated in Poland (475) or Hungary (634).

Institutional uncertainties also abound. While Turkey's central bank is independent, the term of the current central bank governor, Sureyya Serdengecti, expires in March 2006. Mr. Serdengecti might be asked to stay on, or he might not. No final decision has been made yet.

Meanwhile, a number of corruption scandals have surfaced, rattling the political establishment one year before national elections are due in 2007.

Finally, on Turkey's southern border lies Iraq, which only adds to Turkey's political uncertainty given the increasing odds of sectarian war. If the Iraqi Kurds manage to carve out an independent state in northern Iraq, it's not clear exactly how Turkey might respond.

While EU accession talks have boosted the world's confidence in Turkey, we should all remember that these negotiations are going to be a long, drawn-out and contentious process.

Given all these challenges and problems, one thing is clear. Rarely has a stock market reached such heights as Turkey's has in the face of so many looming structural and cyclical impediments.

A large current account deficit, an overvalued currency, exports increasingly under threat from China, a massive unemployment problem, industrial inefficiencies, modest foreign direct investment, political uncertainty — all of these variables, and others, such as the threat of avian flu, to date have done little to dent confidence in Turkey.

Thus far, the search for yield — aided and abetted by global interest rates at record lows — has triumphed over Turkey's shaky fundamentals.

Present circumstances, however, could change as global interest rates rise and investor appetite for risk abates this year, leaving Turkey dangerously vulnerable and exposed.

Whether a sharp pullback or correction in Turkey triggers similar moves elsewhere in the emerging markets remains to be seen. My hunch is that other emerging markets would not go unscathed.