TURKEY'S GOING ADRIFT

The Turkish economy despite impressive performances since the coming to power of the AKP remains fragile and dependent on short-term capital. This makes the economy the most vulnerable one among the emerging countries.

Does Turkey, the star of the emerging countries, a source of inspiration for the Arab revolutions of 2011 and capable of returning the army to its barracks which was ready to get involved in politics , doing a reverse? The European Union, which reopened in late 2013 the chapters of negotiations on accession after a freeze of more than three years, doubts the ability of this country to stay the course of reforms. The dream of Turkey to move from 17th in the world for the size of its economy to the 10th 2023, seems less and less possible. "This has been achieved over the past decade, whether over the army, the judiciary reform, the integration of nearly 15 million rural people in the urban middle class, is impressive," said a European official. Not to mention, as it is claimed to be in the World Bank, the creation of 4 million jobs from 2009 to 2013 , while the European Union destroyed 3,000,000. But in recent months, the European official added, reforms skid . The visit of Turkish Prime Minister Recep Tayyip Erdogan in Brussels on January 21, the first since the last three years, aimed to give a boost to the process of negotiations but in vain.

Without mentioning a suspension of negotiations , Brussels thinks, adds one European sources in Ankara, that Turkey is moving away from the "Copenhagen criteria" that require candidate countries "to have stable institutions guaranteeing democracy, the rule of law , human rights and respect for and protection of the minorities." Since December 17, the Erdogan government was shaken by a corruption scandal that directly affects his family, including his son, the ministers and the businessmen close to the AKP , the Islamist party power since 2002 . Erdogan has overreacted , alleging a conspiracy after the arrest of of the sons a several ministers or the summon of his own son to the court. It is an attitude, according to a senior Turkish official, which gives the impression that Erdogan is "fighting for his political survival." Several hundred officers were relieved of their duties, and after that, judges and prosecutors. The culprit of this plot for Erdogan is none other than his former ally, an imam Fethullah Gülen, exiled in the United States since 1999.

In an interview with European reporters in Ankara, Ali Babacan, Deputy Prime Minister said that already for many years the government "suspected" the Gülen movement to have placed relatives in the upper administration. According to him, the movement manages about a quarter of maternal in Turkey and also schools in 130 countries and includes more than 30,000 businessmen. Faced with this alleged conspiracy, the government adopted, in quick succession, a new justice reform to increase its influence even on the judges and a law limiting access to the Internet ostensibly to protect the privacy of citizens and children.

This conspiracy theory is not new in Turkey. But the scandal that rocks AKP is more serious than Erdogan's party which proclaims itself as the party of purity, anti-corruption , anti -establishment and it comes just months after the demonstrations against the power triggered late May by a project ultimately abandoned, to build a shopping center on Gezi Park in Istanbul. "The political turmoil affect the economic status." The note "The political environment is less predictable. Which could weigh on economic resilience and growth potential in the long term, " was given by the S & P placing in early February the Turkish rating (BB +) with a" negative "outlook. For Turkey, despite a higher growth rate than the European countries - about 3.5% provided by the World Bank in 2014 - has serious weaknesses. "Turkey now pays for his sins of the past five years." It must be funded by the use of short-term capital deficit on current account, which reached nearly 8% of its GDP, worse than the Ukraine and South Africa situation. This deficit is expected to shrink this year, due to the depreciation of the Turkish lira and a reduction in imports, particularly of gold from Iran or a recovery in the euro area, as explained by the Minister of Finance Mehmet Simsek.

But is it enough ? Because Turkey suffers from a low level , both foreign direct investment (FDI) and private savings and a debt of households and businesses. The risk lays in the possibility that capital flight in the short term accelerates. The Minister of Finance, a former economist at Merrill Lynch, recognizes that, since the U.S. monetary tightening , the period of excess liquidity and low interest rates "comes to an end ." The violent rise in the interest rate decided by the central bank, against the advice of the Erdogan government, has certainly halted the sharp drop in the lira. But for how long? Turkey is not "sick man of Europe", as the Ottoman Empire in the nineteenth century, but it is "the most vulnerable of the emerging countries." And this despite the considerable strengths of its youthful population. Erdogan who sees itself as the next president in the first presidential elections in August by direct suffrage, could be written in the annals of the history as a reformer, but he may also end up as a corrupt autocrat. As we approach the municipal elections of March 30, he still enjoys, according to surveys, an approval rate of nearly 40%. Why stop the reforms?

WINTER'S FIRST RALLY HAS BEGUN

The JP Morgan global composite PMI which measures the instantaneous pulse of the world economy, has pointed to a monthly growth pace of 3% by climbing from 53.8 to 53.9 in a difficult month.

It is possible for the developed markets to reach new heights in 2014 within a month by taking back the losses incurred since the start of the year. Regarding the emerging markets, the rally is doomed to take an end in March. Furthermore, the U.S. 10-year bond yields will start to move again towards 3%; we can say that the appreciation process of the U.S. dollar against the emerging markets' currencies has been postponed. The gold and the oil will trade in a narrow band for some time. We can say that the first group waits the clarification of China's outlook for the demand while the second waits for the U.S. inflation.

Let's take a look at the downside risks; the rally faces four major obstacles along its way :

Would the Republicans in the U.S. lock the State on the pretext of the federal debt limit which term has once again arrived? We believe that they would not dare to do it for they would receive a terrible beating in the elections of November this year.

ECB does stubbornly not take precautions against deflation while the euro is overvalued. The slight fall of the EU inflation as well as the decline of the PMI of the members other than Germany are significant threats to the markets.

The pessimistic developments concerning the shadow banking in China can change the agenda at any moment. Experts such as Bill Gross suggest to stay away from the Chinese market. It is clear that without the leadership of China, it will be difficult to have a permanent rally in the emerging markets.

 Turkey will go ahead of this rally all along February.We expect an appreciation in the TL and the State bonds for at least 15 days. the ISE will be affected favorably with the drop in the currency and the interest rates but the poor financial results will limit the rally. Unfortunately, the rally is based on three major misperceptions and we do not expect it to be permanent.

There is the local election of March in Turkey.

The AKP won the fight in the internal politics and the vote in local elections will not be affected very much. However, the AKP and the CHP + MHP votes are very close to each other and the AKP's more likely to lose votes in the coming months.

Turkey's economy has not been affected very much by the interest rates as well as by the global and political shocks: she should return to the growth corridor of 3% - 4% in the second half of the year. Turkey has entered into the monetary normalization with an inflation of 8% and a current account deficit of the GDP as 7%.  Even if the political instability and global unrest take an end, the restoration of the balance in the economy will bring along the slow growth.

The political uncertainty will end after the local elections in March; thus the interest will fall, and the TL will appreciate. Political uncertainty may continue even after the presidential election and Turkey can not carry any longer psychologically this devastating fight.

The rally in TL denominated assets will depend on how much of this misunderstanding is pumped by the media and the investments banks upon the investors. But it is likely that some bad surprises are awaiting us in March. A financial seism that Turkey may likely experience in March will probably shake all the emerging markets.

 

THE DARK ANGEL: ADVENTURES AND MISADVENTURES OF A CREDIT ANALYST

I had started to work as a credit analyst only by a pure chance in a consulting company called General Finance Market on July 2006. Prior to that, I had only a vague idea about credit analysis other than the traditional credit rating procedures which I had learned about it by 1993 while working as a stock analyst in Halkbank. Incidentally, General Finance Market had a job posting on a newspaper requesting a French speaking person to deal with the international correspondence in June 2006. I had applied to this position as well as to a translator position for a company called Emek Pres. I started to work with Emek Pres in the second half of June 2006 but soon I discovered that the company was not paying properly its employees and I started to look around, especially the good news from General Finance Market. On the last week of June, the company called and after a short meeting, I was accepted to the said position.

So, I started to work as a correspondence clerk in General Finance Market. But soon, I realized that their credit analysis department was weak, or virtually non-existent, I would say... I jumped on the opportunity and prepared a report about one of its client companies which the management liked. Before joining the company, I had done some research as to how to make credit analysis as I had only a vague idea about it despite my experience as a stock analyst; I had to concentrate on the short term of the financial analysis with regard to insolvency whereas with stocks, I was looking ahead. Then, I transferred this to my work and the first report was OK as far as the standards were concerned. But I was in need of something more clear cut on the matter.

I turned to a Russian hacker who had access to various sources, including financial ones and asked him whether he could find something about the credit analysis and credit risk assessment. Soon he came up with a bunch of CDs on the matter. It compiled the data of several hundred of thousands of companies together with their risk assessments; it provided a concrete estimate of bankruptcy probability. I took me about a week to work out operational tables for the correct estimation of bankruptcy. At the end, I had developed composite tables for bankruptcy estimation.

Armed with this tool, I went to try it first with some old bankrupt companies that I knew in order to test its effectiveness. One of the companies that I put into the test was Enron and I could determine that it was giving strong signals of bankruptcy as early as 1997 with a probability of 70%. And that figure had reached 80% at the end of 2000. As my confidence on the model grew stronger with the successful testing, I decided to try it on a recent client company which had applied for a credit line. Then I prepared a report of 2 pages at the end of which I stated that the company had 80% probability of going bankrupt. The chairman was furious and dismissed the report as he was trying to strike a deal. In fact, I had paid a visit to the distressed company in Bolu but it was plain to see that things were not going well. 3 weeks after submitting my report, the bad news arrived to General Finance Market: the company had filed for bankruptcy...

The chairman was infuriated and he rushed to my desk and ordered me to do the same work for the other client companies that were on the files. Their number was 140 and it took me about 2 weeks to evaluate them before coming up with a summary report. Out of the 140, only 10 company were eligible to be presented to the banks and among them, only 3 managed to obtain a loan which permitted General Finance Market to obtain good deals.

Basically, the company was saying to the customers that it was not going to take any commissions before obtaining a loan but that there was an expertise report which had to be prepared and be submitted to the bank and it had to be paid. It was with this money that the company was able to meet its administrative expenses. And if the credit line was obtained, then the commission would be collected once the money entered into the accounts.

But in October 2006, one of the company's manager embezzled the money present in the accounts and the company found itself in dire straits. Despite fighting desperately to restore the situation,  the management was helpless in front of the angry customers: there was a cat and mouse event going on between the management and the customers...

But this system crashed with the event cited above and thing started to get tough. The company changed its address and continued its operations in a discreet fashion until June 2007. Needless to say, it was a failure...

During this period, General Finance Market had taken contact with Kayseri Sugar Refineries which was in the need of financing its 100 million USD worth residential project in Kayseri. I had prepared the file and submitted to the management who in turn took contact with Credit Suisse who had proposed 10%. The management of Kayseri Sugar Refineries at first was neutral to the proposition and then, the refusal followed. I was at first astonished when I heard about it but later on, the details had arrived: the payment of the loan would be made in 10 equal instalments while the Kayseri Sugar Refineries was expecting a payment in a lump sum (I suspected that they had other intentions for a portion of that money such as buying for themselves some apartments and fancy cars).

The Turkish companies were generally coming up for a loan demand on three matters: the financing of the needs in working capital, debt restructuring and financing of investment projects. In the first one, the banks requested that the amount of the loan should not be more than the quarter of the sales figures and that the deed that was going to be used as a collateral should be worth at least twice the loan. And also, they did not want to see any financial debt in the liabilities and the company must not have unpaid cheques. As far the debt restructuring was concerned, the banks were generally reluctant to finance it as it meant to be a replacement of a group of financial debt by a single bank loan and thus creating a substantial default risk. But the financing of the investment projects was a nightmare because the Turkish banks did not know how to do it; they were considering the loans as commercial loans and consequently, we had to turn to the foreign banks. Apart from all this, I had to deal with the consistency of the companies' financial statements which were not correct most of the time. It is customary to cook the books in Turkey and I had to ask for the real sales figure. There were three ways of altering the sales figure: the first one involved the practice of making the sales without issuing any invoice; the second one involved a correct sales figure but the costs was overstated by the use of fake invoices; the third one involved both.

On July 2007, I started to work with Rehber Consulting in the same position. But things were going bad in the U.S.A. with the subprime mortgage crisis in August 2007. I estimated that we had only two months to work out the deals. But we were not lucky and the opportunity to obtain bank loans for the companies got into great difficulties by November 2007. In March 2008, we missed a big opportunity of restoring our financial situation when a deal of 4 million USD went wrong when the dollar surged in Turkey. In August 2008, the company failed and the following month, I went to Ankara.

In October 2008, I started to work with G&G Consulting as a credit analyst but I got rapidly involved in other matters such as management of the working capital, investment portfolio management and translations. We had a financial crisis brewing in the country and around the world and there could possibly not be any bank loans that could have been obtained from the banks. So, for a while, I managed the portfolio. Then, things started to get better in the summer of 2009 and I started to prepare the loan applications of some companies. Though the results were varying, it was a successful undertaking.

At the same time, I was also working as a part time translator for Keyhan Translation Services starting October 2008. But as the economy was getting into a bad shape, the company's sales dropped by 60% and it had to switch into a payment based on the number of pages instead of paying a fixed salary. Then the owner came to me and asked how he could solve his financial problem. I advised him to do three things: find new customers, collect the receivables and lower tax payments (in other words, provide translation services without issuing any invoice). Under the economic circumstances, the first one was very difficult and the second one had some positive effect while the third one had mitigated results.

Nevertheless, my experience as a credit analyst was quite interesting for my part because I was able to see how things worked in this area. There is a golden rule in the world if finance: what they teach in the books and what you have on marketplace are widely apart. The books are standard theories which are mostly irrelevant when applied to the marketplace. I had realized this when I dealt with the capital markets. And the same thing happened when I dealt with the credit analysis.

When the banks saw my risk evaluation figure in the reports, they had called my employer and asked questions about it such as where I got the figures and wanted the "program". There were no programs other than the composite tables and I never gave them away. I was also using different set of ratios I had invented in order to evaluate certain items of the financial statements and that also was attracting attention.

I did not get involved into details of the statements, especially the balance sheet but nevertheless, I solved the issue by getting from both worlds. It gave me an edge in the analysis. But I still stay away from cash flow analysis despite some attempts to create a straight forward formula. I must admit that I am still the antique type of analyst...

In the fall of 2007, I had met a former regional director of a prominent state owned bank who had a huge network. When I had presented him the works that I had done previously on analysing credit and the relevant issues pertaining into it, he deliberately said that it was bullshit. So, I asked him why.

He said that I did not know finance. I renewed the question and he said the following: "If you know how to obtain a high return with a low or zero risk; if you know ho to obtain a loan with very favourable conditions and if you know how to pay very low or zero tax, you know finance; otherwise you know nothing." Consequently, I asked him to teach me...

One week later, he invited me to a meeting in the Old Bazaar which I had visited many times before. When I arrived there, I met him in one of the currency and gold selling points. There, I met someone who was very knowledgeable concerning the currencies and the the interest rates. We talked a bit and I realized that I was facing something else. Soon, other persons came and I was invited to a place where I would act as a translator for a discussion about the procurement of a foreign loan.

An hour later, I entered a hotel where a Lithuanian woman was waiting. The company in question was Collins Jeans who needed a foreign loan in order to finance a 170 million USD worth residential project and we were about 10 persons attending the meeting. As I had worked upon the file previously, I knew the issue very well. The discussion carried on for 8 hours. The topic was concentrated on the level of the interest rate as well as the commissions. Basically, the World Bank was going to finance this and the Lithuanian lady wanted to secure 2% of commission whereas the group wanted also to have a 2% commission. But the basic interest rate of Turkey was Libor + 3 and at the time of the event, that meant 8 percent + commissions. At the end of the discussion, the figure came out as 11% but the owner of the Collins Jeans rejected the offer.

I had a similar experience in March 2008 when a company we had found in Kahramanmaras wanted to secure a loan of 4 million USD for an investment project. The project in question was a factory for the production of dairy products; the South-eastern Turkey is well know for stock farming and the owners of the projects were quite enthusiastic about it. But after a rapid analysis of its documents, I had found out that they had paid 200.000 USD for a feasibility report which was, for the most part, a copy-paste work...

I took contact with some banks in order to find a loan but the owners had some unpaid cheques which caused some concern. Also, they did not have sufficient real estate that they could present as collateral for the said loan. Then, one of the members of Rehber Consulting took contact with some lawyers who had ties with abroad. Soon, they took contact with a bank in Thailand who accepted to finance the project. Everything was ready for the signature of the agreement where the commission would be 10%; Rehber consulting taking half of it. But 2 days before the signature, the USD jumped in Turkey and the bank cancelled the deal.

There was also the issue of marketing the letters of credit obtained from foreign banks who were about to expire. And I had the task of contacting first the foreign bank in order to ensure that the document was still valid and then transfer it against commission to the customer who was needing it for the financing of its operations. Generally, they started to appear in October and early November and the company who had it in its possession was trying to sell it to someone who could use it right away. But I was intervening as a translator in the whole affair by taking contact with the foreign banks. Despite being a lucrative business where we could earn 1% at the most, it was exhausting and most of the time, there was no result. But, despite that such an event did not really demanded any financial analysis, it nevertheless required some information about the company in question because, at the end, the banks were getting involved.

In another occasion, one of the members of Rehber Consulting called me in for a meeting and said that he needed my assistance regarding a major textile company. The issue was the following: the member was going to procure false invoice to the textile company who was going to use it to inflate its costs and when the financial statements would come out, I was going to prepare a standard report. I told him that the statements were going to be distorted and in such a case, the banks would see that and would refuse to give any loans. The owner said he knew it but this was the way it had to be done.

We went to see textile company and the owner requested a set of false invoices around 200.000 USD. My partner accepted it and I took the documents with me. While returning to the office, he said that the normal charge for a false invoice is 3% and that Rehber would get 7% but the main idea was not to provide him with the invoices but to secure a customer who was in a need of a loan to finance its investments (which turned out to be the company in Kahramanmaras).

The interesting point in this was that I had learned how the system worked. There were some persons who were specialized in preparing these false invoices and depending on the industry, they had a set of false invoices present in the files. All they had to do was to adjust them according to the need. Then, these false invoices were placed in the company's accounts and the owner thus could retrieve the money from the company. The problem to be solved was how much was going to be retrieved in order to avoid the attention of the revenue services. My guess was that the owner would take out the equivalent of the free cash flow and still carry on the business. No wonder why the owners of the companies with high cash flows are rich in terms of real estate...

There were times where some companies could not secure a loan from the banks due their terrible financial state. And we had to find a way to finance them...

The person that I had met (mentioned previously) knew someone in Switzerland who had 350 million USD in the accounts of Credit Suisse. But this person could not use outside of Switzerland and he needed a way to use it (thus laundering it). The Swiss bank would use his money to provide loan, thus act as an intermediary. In return, that portion would be laundered. I was not feeling at ease with the matter but the guy took contact with him and we sent the documents to see what he could do. The result was nil...

But I had learned something about those Swiss banks...

There is at least 60 billion USD present within the accounts of 2 major Swiss banks and belonging to the Turks. Some of them use their money by "obtaining" a loan from these banks and thus evade any problems with the Turkish State. So, I realized that the foreign financial debt present in the liabilities of the Turkish companies was, for the most part, false: they were represent a disguised equity within the company. The amount of money belonging to the Turks which are present outside of Turkey are estimated to, as of 2008, 150 billion USD. And I would suspect it to be now at least 200 billion...

When I arrived to Ankara and started to work in G&G Consulting, my experience proved to be valuable. And I had also managed to gather some interesting information about the finances of Turkey during the 2008-2009 crisis. The underground economy is not 40% as the State is declaring but is the equivalent of the economy. Worse, all the SMEs are in need to perform tax evasion in order to survive in the business because the taxation is heavy compared to the level of their business.  Consequently, I always expressed doubts over the financial statements of the SMEs in search of a loan. But, we also had to accept them as they were for it would have been futile to fight over the consistency of these.

Due to the fact that I had some contacts in Istanbul regarding the foreign banks, the Grand Bazaar and the Tahtakale currency market, I could follow what was going on. Also, as I had to follow the world, I was quite aware about what was going on in the finance world abroad.

When 1993, I had pointed to my superiors of the futility of taking into consideration of a group when analysing a company (the famous qualitative factors), I got it wrong in 1994 crisis where Turkey and Mexico had identical credit rating but just because USD backed Mexico with  50 billion USD, only Turkey's credit rating dropped significantly, and then right in 2008 when the banks which had a level credit rating got into trouble when they issued poor quality investment vehicles to the public. When the bubble burst, the relationship between the assets and the value of these investment vehicles disappeared with the relevant consequences. Then their ratings were questioned but soon everyone forgot about it.

To sum it up, imagine you have a Holding whose rating is AAA and one of its companies has a normal rating of BBB. But, just because the company belongs to the Holding, it gets a AAA rating treatment. It is assumed that if something goes wrong with the company, the Holding will pay. In the short term, that may sound like being correct but over the long term, it is the opposite.

No wonder why when some investment projects that the companies undertake in Turkey encounter great difficulties in obtaining a loan. It happens that the foreign banks request a guarantee from the Treasury other wise there would no loans available...

Last word: when the commissions are at stake, the analysis is futile.

WORLD MARKETS: WHEN WILL THE TURBULENCE END?

Sales in global markets will continue, the ECB decision and U.S. employment figures will give direction to the markets in general.

Signals regarding the slowdown in the Chinese economy, the Fed's Quantitative Easing exit maintained and the crises in a number of developing countries in world markets and in particular in Turkey, have created a nightmare in the true sense of the word. While all the share indices have closed the week with a loss, the U.S. bonds have seen their premium rise due to the flight to quality. The financial press over the weekend was filled with prophecies of similar crises like the ones in the 1990s regarding the Emerging Markets. One can only ask whether the world is heading to a new crisis? When will this nightmare take an end?

In fact, we are paying the price of the unlimited money printing performed by the Fed, BoJ, BoE and in a limited way by the ECB for the last five years. With the exception of BoJ, once it has been seen that the central banks will no longer print money, a rush escape from the developing countries which had benefited enormously from this endless liquidity  has started. Already, the perception that the developing countries failed to grow as well as the upcoming elections and the political crises in most of these countries had shattered the morale, then the shocks from China and the Fed came along.

We do not have any worries concerning the Wall Street and other stock exchanges of the developed countries. With strong economic growth and high interest rates which are still too low will permit these exchanges to overcome the crisis in a short time. Based on a simple calculation, we can expect the S&P 500 to drop no further than 5% in a worst-case scenario.Unfortunately, we are a bit more pessimistic about the developing countries as a whole. According to Goldman Sachs, the process of adapting to the new era of foreign exchange and interest rate is not yet complete. MSCI of the developing countries may lose 10% more of its value.

This week, we shall see the continuation of the selling of riskier assets. While the U.S. economy will be accelerating in terms of growth, the main concern will be the speeding up of the exit from the quantitative easing by the Fed. the ISM indices which will be published this week and the January non-farm employment figures which will be released on Friday are also important.The December revisions and in the event that the figures of January exceed 250000, one may experience a panic sale in the Wall Street but after that, people will look at the strengthening growth.

As far as the European Union is concerned, unlike the estimate of the majority, we do not expect the ECB to lower its interest rates this week. While we will see the weakening of the EUR/USD, we may experience some sales in the Stoxx600 until strong profits are issued.

Regarding the developing countries, the global PMI indices which will be released during the week are also very important. If in the second half of January, despite the shock, the acceleration in economic activity persist, the assets of the developing countries' markets can survive the crisis.

We are absolutely certain that the world is not on the brink of a new crisis. We are in a transition phase which is going to end with the Fed's shock interest hike due in 2016. During this period, all the financial assets will be repriced. In the process, it is very probable that the U.S. dollar and the U.S. bonds' interest rates will rise while commodities, gold, euro and yen will depreciate. This process will be painful for the developing countries but with a few exceptions such as Turkey, there are no imbalances similar to the 1990s which will drag the economies into the abyss. We consider that the scenario regarding a strong growth is still firm despite the currency and interest rate shocks. In the event that the prices of the developing countries' assets drop further (say between 10 % and 30%),  we believe that a strong buy will definitively start.