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Trouble in Paradise

26 March 2017

The much-touted revisions to Turkey’s GDP figures, which lifted the average annual real growth rate to 7.3% in 2010-2015 from previously average 4.7%, have inadvertently revealed several inherent weaknesses of the Turkish economic growth model. According to the revised GDP series, construction spending which represented some 50% of the total fixed capital investments, accounted for about one third of the cumulative increase in real GDP in 2010-3Q16, registering an average real growth rate of 13% per annum compared to avg. real GDP growth rate of 6% over the same period of time. As investment spending on construction lifts the value-added in almost all sectors, particularly in household durables and related services as well as activity in various service sectors such as real estate, finance and transportation, we believe direct and indirect construction-related spending might have reasonably accounted for about 40% of real economic growth in 2010-2016. Put differently, Turkish economy has enjoyed a period of very high growth rates largely on the back of domestic consumption and construction activities, which would not be a big problem, had it not been mostly financed by external debt.


Turkey: Real construction spending vs. real GDP growth Turkey: Cumulative contribution to increase in real GDP in 4Q09-3Q16
Source: TurkStat Source: TurkStat


A debt-fueled consumption boom rapidly ending

The exponential growth in private consumption and construction activities beyond what Turkey’s domestic savings could afford has inevitably led to a massive credit build-up, particularly in the post-Lehman global liquidity glut environment. We observe that Turkey’s total private non-financial sector (i.e. non-financial companies and households) debt (both domestic and external) to GDP ratio has sharply risen to the current level of almost 100% from 60% in 2008, surpassing the EM median level (ex-China) by a wide margin. In fact, Turkey has registered the second largest private non-financial credit build-up in 2009-2016 following China, which is a current account surplus economy unlike Turkish economy.


Turkey: Total private non-financial sector debt to GDP (%)* Turkey: Change in total private non-financial sector debt as % of GDP in 2009-3Q16
Source: BIS
*non-financial corporates and households/including all types of debt instruments
Source: BIS


While the Turkish households have also amassed substantial debt levels in the past decade, corresponding to about 50% of household disposable income in 2016 vs. 5% in 2002, the rapid rise in non-financial corporate debt seems more alarming, in our view. We note that private non-financial corporate debt (domestic and external) to GDP ratio rose to 83% of GDP (vs. EM ex-China median of 50%) as of the end of Jan-2017 from 46% in 2009, registering the second largest debt-to-GDP build-up in the EM universe following China. While total external borrowing of non-financial corporates stood at US$138 bn as of the end of Jan-17 compared to US$105 bn as of the end of 2009, total domestic debt (commercial loans, domestic corporate bonds, factoring and leasing) rose to TL1.5 trn as of Jan-17 from TL300 bn by the end of 2009, of which roughly 50% was fx-denominated and fx-linked.


Turkey: Domestic and export sales of Turkish non-financial companies* Turkey: BIST Industrials and Services domestic and export sales*
Source: CBT Real Sector Financial Accounts Survey
*Domestic sales growth figures are in nominal CAGR terms / Exports growth figures are in equally weighted USD/EUR basket CAGR terms
Source: Rasyonet EquityRT
*in equally weighted USD/EUR basket terms


Total sales started to stagnate after 2012

Despite extraordinarily high economic growth rates registered in 2010-2015, based on the CBT’s Real Sector Financial Accounts Survey, which covers about 9,000 firms, we see domestic sales growth of the Turkish non-financial companies has plummeted to an average 8% in CAGR terms in 2012-2016 from 16% in 2005-2011, while export sales stagnated in fx terms in 2012-2016 compared to 5.5% CAGR in 2005-2011. We also note, in real terms (i.e. after adjusting for inflation), there was no sales growth at all in 2012-2016. The reported aggregate figures of BIST Services and Industrials also confirm this protracted decline in corporate sales, which implies a broad-based sales recession in the past 5 years.


Turkey: Aggregate corporate profits growth rates (2005-2016) Turkey: Aggregate corporate profits growth rates 2005-2012 vs. 2012-2016 CAGR*
Source: MOF, Rasyonet EquityRT Source: MOF, Rasyonet EquityRT


Since the high growth rates seen in private consumption expenditures in 2003-2015, averaging 7% pa in real terms (excluding the global crisis years of 2008 and 2009) has been largely predicated on an exponential increase in household debt where non-mortgage household debt more than tripled in 2009-2016, domestic consumption started to slow down due to a sharp fall in consumer credit after 2012. We note that annual growth rate of total non-mortgage household debt declined to avg. 6% in 2014-2016 from avg. 35% in the preceding 10 years, hampering households’ ability to maintain high rates of consumption. On the other hand, while a combination of macroprudential measures that were put in place in 2012 in order to curb excessive debt accumulation and consumption along with a steady rise in real wages helped facilitate some household deleveraging in 2013-2016, the government’s recent efforts to spur economic growth via easy and cheaper credit seem to have boosted consumption again in the past 6 months. In our view, these efforts to boost domestic consumption is likely to prove short-lived due to rising unemployment and falling consumer confidence in the face of political uncertainties.


Turkey: Consumer debt growth has outpaced wage growth by a wide margin in the past 10y Private consumption growth has slowed substantially due to consumer credit crunch
Source: TurkStat, BRSA Source: BRSA, Rasyonet EquityRT


Slumping sales along with a sharp increase in financial expenses boosted largely by fx losses has weighed on corporate profits, where the aggregate net profit growth of BIST Industrials and Services declined to 2% (in CAGR terms) in 2012-2016 from 18% in 2005-2012. Our calculations based on corporate tax filings of all firms in Turkey (some 700,000 corporate tax payers) published by the Ministry of Finance are in line with the profit growth figures of the listed firms, implying an economy-wide decline in corporate profits.

Debt servicing capacity of Turkish corporates has been severely impaired

The toxic mix of sales recession and peak corporate leverage has consequently impaired Turkish firms’ debt servicing capacity, which was one of the key factors behind the rating agencies’ decision to cut Turkey’s rating to junk level. The impact of weaker currency and high leverage has led to a sharp deterioration in Turkish firms’ debt servicing metrics such as net debt-to-EBITDA and financial expense coverage ratios. Our calculations based on the CBT data show that the average net debt-to-EBITDA ratio of large firms has increased to 3.0x as of the end of 2016 from about 1.0x as of the end of 2009. That said, the exponential increase in medium-size firms’ net debt-to-EBITDA ratio to above 9.0x as of the end of 2016 (vs. 4.5x in 2009) is particularly problematic in terms of solvency if the economy settles for a sub-3% annual growth rate in the next few years, as we expect, not to mention the potentially devastating impact of further currency weakness. The BIST listed firms’ figures indicate a similar worsening in debt serviceability metrics, particularly for the BIST Services Companies, where median EBITDA-to-financial expenses ratio has plummeted to 0.9x as of the end of 2016 from 2.4x in 2012. Put differently, these companies have not generated sufficient earnings (EBITDA) to cover their financial expenses which comprise of interest expense and fx losses in 2016. Largely due to higher financial expenses, some 30% of the 160 firms listed in the BIST Services and Industrials indices posted bottom-line losses in 2016 compared to average 20% in 2005-2015 excluding the crisis year of 2009 where almost 40% of the listed firms had posted net losses. That said, the protracted slump in corporate profits since 2012 cannot be solely attributable to financial expenses, as EBITDA margins (a measure of a company’s operating profitability excluding taxes, financial expenses, and depreciation) have also declined substantially across the board.

Declining capex and lower profitability: a vicious cycle

The current state of the economy tells us a very familiar story: the end of a consumption boom on the back of excessive debt build-up financed by foreign borrowing. As credit crunch sets in, households cannot borrow more to maintain high levels of consumption, which in turn weighs on domestic sales. Firms find themselves saddled with too much debt against falling sales, facing a structural decline in profitability. Consequently, firms start to cut back on new investments, save maintenance, as they struggle with too much debt and a chronic lack of new profitable investment opportunities. As investment and consumption growth wane, unemployment starts to pick up, which leads to a further decline in consumption…so on and so forth. In financial parlance, this is called a “debt death spiral”.

As shown in the charts below, gross fixed capital formation in machinery and equipment has sharply declined to avg. 2% pa in real terms in 204-2016 from avg. 16% in 2010-2013. Capex figures of the BIST firms and capital goods imports also confirm the structural slowdown in private investments. On the other hand, due to slower sales growth and rising financial expenditures, the average return on equity of BIST firms have been trending down in the past 4 years. With exception of a handful highly profitable firms such as TOFAS, Ford Otosan, Tupras, Arcelik and BIM, the average ROE of BIST Services and Industrials firms has declined to 4% by the end of 2016 from 16% in 2012.

If history is of any guide, it seems to us the Turkish economy has entered the final phase of a painful deleveraging process which will have far-reaching economic, social, and political consequences. Whether the inevitable deleveraging will take place in an orderly fashion or end up in another financial mess remains to be seen. However, the odds for the latter case have increased palpably in recent months, in our view.


Turkey: Capital goods imports, BIST Capex, and Gross Fixed Capital Formation** Turkey: Turkish firms’ profitability has been on a secular decline since 2012
Source: Rasyonet EquityRT, TurkStat
*Capex growth figures are adjusted for currency mix of capex
**gross fixed capital investments in machinery and equipment
Source: Rasyonet EquityRT
*Averages weighted by 2016 net sales

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