Emerging Markets Insights

While Turkey is one of EMEA’s most attractive growth markets, MNCs face significant challenges in building a profitable business there. According to Frontier Strategy Group’s clients, strong local competition is one of the biggest obstacles to growth in Turkey. MNCs can improve their profitability and boost their performance in Turkey by leveraging increased scale to cut costs and create economies of scale.

FSG’s research shows that scale leads to improved profitability in Turkey at a higher rate than it does in the BRIC markets. One way in which MNCs can take advantage of this is through M&A. The M&A market in Turkey is particularly favorable due to the weak lira, the slowdown of the economy which is depressing valuations for export-oriented local players, as well as the upcoming introduction of Turkey’s new commercial code which will improve transparency and strengthen shareholders rights. As competition for the best assets from private equity funds intensifies, MNCs will have a limited opportunity to take advantage of this favorable environment and reap the benefits of improved profitability in Turkey.

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If you are not going direct in Turkey, then you are likely missing out on a tremendous opportunity for your business. In our latest research on the market opportunity in Turkey, Frontier Strategy Group identified three questions you should ask about the state of your operations in Turkey:

1. Turkey’s M&A market is ripe for acquisitions, but MNCs increasingly have to compete with private equity funds for the best assets. How is your company leveraging acquisitions to grow its presence in the Turkish market?
2. MNCs leveraging Turkey as a regional sales hub are 9% more profitable in Turkey than the global average for their company. How is your company taking advantage of Turkey’s growing position as a regional hub?
3. Turkish distributors are 23% cheaper as a percentage of profit margins than the global average. How effective is your company at leveraging distributors to increase market penetration in Turkey?

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Turkey had a strong 2011, with GDP growth exceeding 8% for the year. However, we expect a noticeable slowdown in 2012 to 1.7% YoY. The main drivers of the slowdown are weakening industrial production as eurozone demand for Turkish exports slows, tightening credit conditions in the eurozone, and rising inflation in Turkey. These factors will come together to put downward pressure both on business and consumer demand and will affect multinational companies across a wide variety of sectors.

However, Turkey has consistently surprised on the upside over the past several months, and a very gradual slowdown of the economy in 2012 is becoming increasingly likely. What is more, as the Turkish lira remains relatively weak, the exchange rate will favor companies exporting from Turkey and will partly offset the declin in export demand from the eurozone. We expect Turkish growth to accelerate once again in 2013 as the effect of the eurozone crisis wears off and Turkey’s current account deficit narrows, improving market confidence in the country’s economic stability.

Meanwhile, 2012 is a year of opportunity for companies looking to invest on the Turkish market. With tighter credit conditions and low export demand putting pressure on the local companies’ financial stability, a weak currency, and lower investment from the eurozone, MNCs will have more targets to choose from for M&A this year, at a lower cost of investment, and facing weaker external competition for priority targets. With the market expected to rebound next year, companies that invest in Turkey this year will find themselves positioned for stronger growth in 2013 and beyond.

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The outlook for Central and Eastern Europe is getting gloomier by the day as the eurozone crisis is weakening regional economies. While there is a significant level of volatility and uncertainty around the eurozone’s performance in 2012, there are several clear trends that will impact MNC performance in CEE this year:

• 2012 GDP growth projections are low across the region and will be revised further down
• Decreasing exports will hurt local producers
• Tight lending will limit local companies’ ability to make investments and will dampen consumer demand
• Austerity measures across the region will slow government and consumer spending but will ease inflation
• Local currencies will remain volatile and weak against the dollar

MNCs should plan to adapt their product portfolios, purchasing policies, and partner relationships to respond to weaker demand and tighter lending conditions in CEE.

However, not all CEE markets will fare the same – some will be impacted more than others (see table).

This creates opportunities for MNCs that pay attention to the nuances of the different regional economies and zero in on the markets that will outperform the rest of the region. The two most obvious ones are Poland and Turkey. In Poland, resilient domestic demand will sustain growth despite the negative impact of slowing export demand. Turkey will definitely see a slowdown this year, but its macroeconomic fundamentals remain solid and the country offers excellent opportunities for long-term growth.  Both countries are presently experiencing currency depreciation, creating opportunities for cheap investment and acquisition of attractive local assets at a discount.

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Trend

• Turkey’s economy is growing at a slower pace than it did in H1 2011, a trend that will become more pronounced through 2012

Drivers

• Demand for Turkish exports is slowing as the sovereign debt crisis drives recession in the eurozone, Turkey’s most important trade partner
• The Central Bank of Turkey is tightening credit conditions to stem the depreciation of the Turkish lira. This will slow both consumer and retail credit growth in 2012 and will contribute to slower GDP growth for the year

FSG View

• B2B demand from Turkish customers is decelerating, but the pace of the slowdown will depend on customers’ target markets:
  • Turkish companies exporting to EU markets are most exposed in 2012 because of the slowdown of demand from European markets
  • Turkish companies exporting to fast-growing Middle Eastern and African markets, as well as domestic FMCG companies, will be the least affected by the slowdown because demand from these markets is less dependent on EU demand
• MNCs should monitor growth projections for the euro zone and Turkish Central Bank actions as leading indicators of the slowdown in Turkish economic growth for 2012
• Even though its growth is slowing, Turkey will remain one of the most attractive markets in CEE

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The Turkish lira lost 16% against the dollar in the past 3 quarters and has been one of the worst-performing emerging-market currencies this year. This trend has already started to hit bottom lines and companies are planning to hedge against losses.

There are winners and losers from the lira’s weakness through: local companies and MNCs operating in lira and importing heavy raw materials or parts into Turkey are suffering from rising input costs. On the other hand, companies producing locally and exporting from Turkey are benefitting from Turkey’s stronger export position.

What is causing the lira’s weakness? There are two leading indicators that are driving the lira’s underperformance. First, the country’s rising current account deficit is pressuring Central Bank reserves and the exchange rate. Second, the sovereign debt crisis in Europe is driving investors away from emerging market currencies and toward the dollar, further weakening the lira.

While Turkey’s central bank could hike interest rates to strengthen the lira, the bank has resisted such a move as it would slow down the economy at a time when exports to the EU are already being hit by the sovereign debt crisis. Plus, an exchange rate hike will only be effective if there is exchange rate stability. If the lira is rapidly depreciating against the dollar, interest rate hikes will be seen as a desperate move by the central bank, causing additional portfolio investment flight and further driving down the lira.

As a result, MNCs should anticipate the lira to remain weak through year-end 2012, before appreciating against the dollar in 2013: “The Turkish lira depreciation is not a permanent trend, but a short-to-medium term one,” says Frontier Strategy Group Expert Advisor Kerim Kotan.

Companies producing in Turkey should anticipate lower exchange rate-adjusted costs through next year, while companies selling indirectly to the market should anticipate reduced buying power for dollar-denominated goods. Fahhan Ozcelik, FSG Expert Advisor, also recommends that MNCs operating in Turkey take advantage of the government’s planned incentives for local exporters. One way MNCs can do this is by partnering with local suppliers for semi-finished goods, especially in industries such as textiles, motor vehicles, and electrical machinery.

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Frontier Strategy Group built a proprietary model in 2008 to test the assumption that “emerging markets are decoupled from western economies (G7)”. We found that certain markets such as Nigeria and Peru were not only decoupled but provided multinationals with consistently high growth opportunities.  Conversely, growth in markets such as Turkey, were highly dependent on a recovery in western economies.

Surprisingly, in 2011, our model shifted to indicate that emerging markets are no longer thought to be as decoupled as before. Very few markets such as Morocco and Indonesia provide above average growth opportunities with less dependence on the status of western markets.

In 2008 we built a model to understand the global impact of a recession:

2011 data shows markets are more coupled than before

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Explosive deterioration of its relationship with Israel. A trip of the post-Arab Spring Middle East. Turkey’s foreign policy is generating quite a lot of attention in the Middle East these days.

Beyond its political implications; however, the policy of courting key Middle Eastern countries like Egypt also has a serious domestic driver: Turkey’s economy is charting precarious waters.

Turkey has been struggling with a rising current account deficit driven by strong domestic demand. The rise in household consumption has been financed by capital from Europe, making Turkey increasingly vulnerable to an outflow of short-term capital as European economies continue to struggle.

The other pillar of Turkey’s economy – exports, is also threatened by the potential of a Eurozone recession. With over 50% of Turkish exports going to the EU, Turkey is particularly vulnerable to a drop in demand from such key countries as Germany, Italy, and Spain. FSG Monitor estimates that a US-EU recession would lead to a 2% drop in Turkey’s GDP in 2012. The projected decline may not be as dramatic as in other countries in the region, but compared to Turkey’s Q1 2011 11.6% GDP growth, followed by 8.8% for Q2 2011 (Turkey had the highest H1 2011 GDP growth in the world), it’s very significant.

In this unstable environment, the Turkish government has announced it will seek to promote export-oriented domestic production. But this strategy will only work if there is enough demand for Turkey’s increased exports. With the European economy in a shaky state, Middle Eastern markets will be increasingly instrumental to Turkey’s economic stability. Currently, the Middle East is the second biggest regional market for Turkish exports, accounting for 20% of the country’s exports, plus another 4.9% of exports going to North Africa.

Turkish businesses are clearly seeing the writing on the wall and are aggressively seeking expanded influence in the Middle East, as evidenced by Prime Minister Erdogan’s large business delegation on his recent trip to Egypt and his promise to increase trade between the two countries to US$5 billion.

In this context, MNCs should expect Turkish competitors to aggressively pursue opportunities in the post-Arab spring markets. As we already discussed, MNCs with overly risk-averse strategies in the region can fall behind regional competitors with a greater risk appetite. It also means, however, that MNCs with Turkish partners can use these relationships in support of strategic expansion in the MENA region, benefitting from the good will Turks are enjoying among the region’s populations and leadership.

In this context, the role of Turkey as a manufacturing hub for the Middle East and North Africa region is becoming increasingly attractive, not just to MNCs but also to the Turkish government itself. As a result, MNCs with local production facilities meant for export to the region are well-positioned to lobby the Turkish government for additional incentives and support.

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From MarketWatch

Standard & Poor’s Ratings Services raised its local-currency sovereign ratings on Turkey to investment grade at BBB- from BB+ on Tuesday.

In a statement, it attributed the local-currency upgrade to its “view of continuing improvements in Turkey’s financial sector and the deepening of local markets,”

The news briefly shocked traders more than it should have.

Some news agencies mistakenly reported that it was the nation’s sovereign rating that was lifted to investment grade, instead of the local currency rating, which temporarily added to strength in Turkish stocks, according to The Wall Street Journal.

The Turkey ISE 100 index  XX:XU100 had climbed by as much as 6.5% Tuesday, then eased to post a gain of 5.1% for the session.

Still, the S&P move is certainly a promising one. “S&P is simply confirming what smart investors and leading multinationals already knew,” said Matt Lasov, director of global research at Frontier Strategy Group — that “Turkey looks a lot more credit worthy than many investment grade markets in Western Europe.”

The local-currency rating upgrade also strengthened the Central Bank of the Republic of Turkey’s “hand for further policy easing,” as pressures on the lira are more likely to recede with the investment grade, analysts at BNP Paribas, said in a report.

Given that, they expect the central bank to cut its policy rate by 50 basis points till the year end, if the Federal Reserve introduces another round of quantitative easing.

In recent trading a dollar USDTRY bought 1.78 Turkish lira, compared with around 1.72 lira at the beginning of September.

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Rising concern about the euro zone crisis gathers above the region like a dark storm cloud. While Poland’s economy is positioned to weather the storm, many other countries are quite exposed to regional economic instability, including Bulgaria, Hungary, Romania, and Ukraine. A drop in trade with the EU could squeeze the Turkish economy, which has grown increasingly dependent on Europe for FDI and as an export market. Russia hopes to ride the continuation of a good harvest and strong oil prices for a strong finish to 2011

• Bulgaria: The economy is gradually recovering but inflation, low investment, and the euro zone crisis will continue to weigh on growth
• Croatia: Despite welcome news on its EU membership, Croatia continues to struggle with serious economic problems
• Czech Republic: A surge in foreign investment in the local currency would threaten export growth, which is a critical element to the Czech economy
• Hungary: Hungary’s economy is intricately tied to the region, which is hurting its short-term economic outlook
• Kazakhstan: The government decision to block internet sites and ongoing labor unrest taint the investment climate
• Lithuania: With inflation stabilizing and the economic recovery on track, consumer demand will support growth more actively in H2 2011
• Poland: While the euro zone crisis is bad news for all of Europe, Poland’s economy looks set to weather the storm better than most
• Romania: Romania’s strong export figures are leading economic expansion, but the euro zone crisis is a threat to this engine of growth
• Russia: Decelerating inflation and declining capital outflows underline an improving economic outlook
• Serbia: Serbia’s arrest of war criminal is offset by rising tensions with Kosovo that are disrupting trade
• Slovakia: A proposed draft healthcare law, likely to be adopted, will undermine pharma companies in Slovakia
• Turkey: Government policy and the external environment will likely lead to a moderate economic slowdown
• Ukraine: The local economy continues to recover, but euro zone crisis could derail this year’s progress

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