January 2010

DenizBank Political & Economic

Update

Turkey

Politics… Hard times ahead with Israel…

Economy… The recovery is on the way Inflation has turned to north Real interest rates are in the negative territory The focus of the budget will be on the expenditure side in 2010

Banking Sector… Good news from banking sector: decreasing NPLs and provisions in addition to robust funding…

2

Politics

Economy

Economy

DenizBank Political & Economic Update DenizBank Political & Economic Update

Politics

Hard times ahead with Israel… Israeli defense minister Ehud Barak made a one-day trip to Turkey, the highest-level visit by an Israeli or Turkish official to the other country since Prime Minister Recep Tayyip Erdogan's confrontation over the Gaza conflict with President Shimon Peres at the World Economic Forum in Davos, Switzerland, in January 2009. In his visit, Mr. Barak met with Turkish foreign minister Ahmet Davutoglu, just days after relations between the two countries got very tense. Israel's deputy foreign minister Danny Ayalon humiliated Turkey's ambassador on television intentionally sparking outrage in Turkey. Later, Israel apologized for the incident. It is not surprising that the main effort to restore the relationship is coming from the two militaries, which have formed its basis ever since the alliance was formed in the mid-1990s. At the time, the alliance gave Turkey access to technologically advanced military equipment and Israeli intelligence capabilities. Turkey was fighting a counterinsurgency war with terrorists who had bases in north of Iraq and Syria. Turkey is the only regional partner Israel has in terms of military relationship. In the 1990s, Israel and Turkey signed more than 20 military agreements. One called for four joint air force training sessions a year in each country. The two navies participated in joint exercises and staff officers collaborated on war-game simulations. Deals like Israel's modernization of 54 Turkish Phantom jets helped military exports reach $1 bn during the decade. Moreover, Israel supplied radar systems and missile components. But in the past decade, the collaboration has become less vital for both sides. Mr. Erdogan's government is taking a much tougher stance in Israel's role in Gaza and the West Bank, while he re-establishes relations with its Muslim neighbors, where criticizing Israel is very common. Signs of restoration of relations with its Muslim neighbors are many. Turkey last year held its first joint military exercises with Syria, signed many agreements with Iraq, and recently established visa free travel with Lebanon. Lately, Turkey played a special role in the diplomatic talks between Afghanistan and Pakistan. For Israel, the relationship with Ankara has become less critical as well. A growing commercial relationship with India is surpasses military business with Turkey. Also the conventional military threat from Syria has decreased and Iraq does not pose a threat any more. The relationship between Turkey and Israel will survive for sure, but with less vigor. Indeed, since Turkey's removal of Israel from planned NATO air exercises last fall, the two militaries in December conducted a joint search-and-rescue exercise in the Mediterranean. Regardless of rising tensions, Israel underlines how important Turkey is and emphasizes having good relations with Ankara. However, putting relations back on track would necessitate many more high-level meetings. Israeli Trade Minister’s visit in November, Prime Ministers’ meeting during the Copenhagen Change Summit and the recent visit of the Defense Minister are important steps for future relations with Israel. Ankara, by pushing for an improvement in the Gaza situation and reconciling with the Arab world, restrains relations with Israel. But, the basis of the relations with Israel strengthened particularly in 1990s will make it possible for two countries to overcome the stormy weather.

Jan-10 Jan-10

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DenizBank Political & Economic Update

Economy

The recovery is on the way… After the surprisingly good figure of October, the industrial production contracted by 2.2% in November compared to the same month a year ago (Figure 1). The realization was much worse than market’s expectation of 2% increase. However, we expect to witness a secular upward trend starting from December due to the reasons stated below:

1- Bank loans, especially the consumer loans, have gained pace in the last couple of months. The historical low real and nominal interest rates were instrumental in this growth in addition to the recovering economy. DenizBank’s forecast for 2010 is approaching towards 20% in the conservative scenario, given that 2009 growth for retail loans (including credit cards) was 13.7%. 2- Exports, which are one of the most prominent indicators determining the industrial production trend, are drifting up. Moreover, the preliminary data of Turkish Exporters Association (“TIM”), exports signaled 23% increase in December on YoY basis. 3- The inventories of the real sector are on the rise. Total inventories of industrial, consumer (both cyclical and non-cyclical) and basic material companies listed in ISE (Istanbul Stock Exchange) (that composes 29% of total MCAP) have plunged following the severe crisis started in the last quarter of 2008. Total inventories bottomed as of Q12009 and have stayed flat through second quarter. The inventory reading of Q32009 proved that the inventory cycle has matured and industrial production cycle is rebounding (Figure 2). 4- Seasonally adjusted industrial production figures also depict a more favorable picture (Figure 3). Following an 18.5% decrease between March 2008 and March 2009, the Turkstat’s index adjusted for seasonality and calendar effects surged by a massive 9.2%.

-2.2%

-25%

-15%

-5%

5%

15%

1905 2008 2009

6.5%

-12.6%

Figure 1: Industrial Production Growth

Annualized

Month on Month

8.08

11.76

9.178.10

8.39

8

9

10

11

12

Q3-2008 Q4-2008 Q1-2009 Q2-2009 Q3-2009

(TL bn)

Figure 2: Total Inventories of Companies Listed in IMKB100

Figure 3: Industrial Production (Seasonally Adjusted)

90

100

110

120

2005 2006 2007 2008 2009

9%18.5%

Mar.08 Mar.09

Jan-10

4

Economy

DenizBank Political & Economic Update

Economy

DenizBank Political & Economic Update DenizBank Political & Economic Update DenizBank Political & Economic Update

Economy

5- Last but not least, there will be a strong base year effect due to the fact that the most severe contraction has started in December 2008 by an enormous 17.8%. This will be one of the most important drivers of increasing industrial production data in the next months.

Inflation has turned north The base year effect does not always look good as it is the case for industrial production. On the inflation front, it is working in a negative way such that it has jumped from 5% as of June to 6.53% in December 2009, still well below the 2009 year end inflation target of 7.5% of the Central Bank of Turkey (“CBT”). Additionally, the core indices still remain subdued. That is the main reason behind the inflation expectations still remaining in the comfort zone. On the flip side, we expect the yearly CPI to surge suddenly above 8% in January and stay around those levels through the summer 2010 due to the i- low base effect, ii- reviving demand, iii- higher commodity prices and iv- tax hikes (for instance; tax hike for tobacco will add 1% on YoY inflation in January 2010). The CBT is aware of this and has prepared the markets on several occasions that a gradual increase in inflation is expected in the first half of 2010 and this will not effect its policy rate decision. As per the CBT, the base effect will disappear starting from the second half of 2010, the CPI inflation will drift lower and will be in tandem with the year end target of 6.5%. In the CBT’s quarterly inflation report conference, Governor Yilmaz has reiterated CBT’s expectations for a temporary rise in inflation due to one-off factors. According to the CBT, there are some improvements in output gap, loans and labor conditions, but not to an extend to cause permanent rise in inflation; yet the CBT has drifted its year end inflation targets up for 2010 and 2011 from 5.4% to 5.9% and 4.9% to 5.2%, respectively. The Bank aims to shape the future inflation expectations to some extend. However, we think that rate hikes may come on the agenda not that far away. The market players have already started requesting the CBT to initiate rate hike process starting from second half of 2010. For the possible outcomes of the rate hike on the banking sector, please refer to DenizBank Monthly-December 2009.

Real interest rates are in the negative territory Real interest rates have turned to negative 5 bps. in January (Figure 5). Let’s assume that the March CPI data on annual basis reaches 9%, which is a very plausible scenario under current inflation trend given the details above. Such a CPI figure appears to carry 12 months forward inflation expectations above 8%, implying -1.3% real interest rate for a country with 1, 2 and 3 notches below investment grade respectively by Fitch, Moody’s and S&P!

6,79%

12.0%

6,53%5%

10%

15%

2005 2006 2007 2008 2009

Inflation

Expectation

CPI

Figure 4: CPI and CPI Expectation (12M Fw)

6,79%

6,72%5%

10%

15%

20%

2005 2006 2007 2008 2009

Figure 5: Policy Rate & Inflation Expectations

Expected Inflation

Policy Rate (Compound)

%10.1

Jan-10 Jan-10 Jan-10 Jan-10

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DenizBank Political & Economic Update

Economy

For comparison purposes, one year inflation expectation for the U.S., a top notch sovereign, derived from the difference between nominal and inflation-linked bond yields is standing at 1.28% as of today. Taking 0.25% Fed Funds rate into consideration, U.S.’ real interest rate is standing at -1.03%. The markets, therefore, reacted quickly and bond yields went up (Figure 6). Hopefully, one notch rating hike of Moody’s as of January 8, 2010 (following Fitch’s 2 notches hike in December 3, 2009) came to the rescue. For the following months, the markets are currently expecting S&P to join the hiking club. S&P has recently officially announced that Turkey’s rate is under review. However, more importantly, Turkey needs a stronger “anchor”, namely IMF, to stay immune against any unpleasant surprises, in our view. In the last days of 2009, local media reported that Prime Minister Erdogan has announced in an exclusive party meeting that they are very close to sign a two year agreement with the IMF. Later, Deputy PM Babacan talked positively on a prospective IMF deal. The expectations regarding an IMF deal lasted until the markets witnessed mixed signals on the deal from the government side, once more. We got used to that kind of unpredictable announcements from the government officials since the beginning of last year. But, this time is different since the fiscal and the monetary risks are mounting.

The focus of the budget will be on the expenditures side in 2010

2008 2009 2008 2009

December December Jan.-Dec. Jan.-Dec.

Expenditures 23.9 27.7 16% 226 267 18%

Non-Interest 22.1 26.7 21% 175 214 22%

Interest 3.2 3.6 12% 49 56 15%

Revenues 15.1 21.9 44% 209 215 3%

Tax Revenues 12.0 18.2 51% 168 172 3%

Income Tax 3.1 4.7 51% 38 38 1%

VAT 1.3 3.6 174% 17 21 24%

Special Cons. Tax 3.3 4.1 24% 42 44 4%

VAT on Imports 2.1 3.0 43% 30 26 -13%

Budget Balance -8.8 -5.9 -33% -17 -52 206%

Primary Balance -6.9 -4.8 -30% 34 1 -97%

Table 1: Central Gov. Budget Realizations (TL bn.)

Nominal

Change (%)

Nominal

Change (%)

The deterioration in public balances is becoming more visible every month. The Central Government Budget posted a deficit of TL5.9 bn in December. Although the reading compared favorably to the TL8.8 bn deficit secured a year ago in the same month, 12 months deficit has jumped to TL52 bn from TL17 bn a year ago, corresponding a whopping 206% increase (Table 1). Since last year, the impact of a weak economic activity has taken its toll on tax revenues. However, in the last couple of months, a visible recovery in both direct

9.02%

5

9

13

17

21

25

Sep-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09

(%)

Policy Rate

(Compounded)

Benchmark

Bond Yield (Compounded)

O/N Eq.: 6.50%

16.75%

(As of 26/01/2010)

Figure 6: Benchmark Bond Yield and Policy Rate

Jan-10

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DenizBank Political & Economic Update

Economy

and indirect tax collection came as a relief. Thus, Turkey has succeeded to reach a nominal 3% increase in tax revenues in the crisis year of 2009 (and GDP contradiction around 6%), which shows that the government’s 16% increase projection in its Medium Term Programme targets is attainable in a year with GDP growth topping 3.5% – given that numerous privatizations on the pipeline would come to frution in 2010- On the murky side, the increase in non-interest expenditures is at its full-speed and does not show any sign of deceleration (Figure 7). Given that the general election is scheduled to be held in November 2011, 7.5% increase forecast for non-interest expenditures appears too difficult to be achieved, in our view.

-5%

5%

15%

25%

Dec-07 Jun-08 Dec-08 Jun-09

Figure 7:Tax Rev. vs. Non Int. Exp. Increase (3M Rolling)

Jan-10

7

DenizBank Political & Economic Update

Banking Sector

Good news from banking sector: decreasing NPLs and provisions in addition to robust funding… The most important change in the banking sector in December was the turnaround in the NPLs, both as a share of loans and absolute amount. The NPL ratio has reached its peak at 5.8% and has gradually decreased since then. The mentioned change in the trend is very crucial both for the banking sector and the economic growth. Although the loans were on the rise, the rise was slower than the rise in funding, especially deposits. Instead, the sector was increasing its securities portfolio, and was cautious about aggressive growth in loans, especially in the SME loans. That is the reason why we believe the SMEs will benefit the most from this trend change. As related with decelerating NPLs, the provision expense was on the decrease as of November. On the income statement side, we do not have the December figures, but the decreasing NPLs point out lower NPL provisions for the next months. This ,for sure, will be the most influential factor for the profitability in 2010. By taking the deceleration in NPLs and NPL provisions and diminishing bond appetite of the banks due to end of easing cycle, the banks have to find a place to park their vast amount of liquidity. The increase in the loans would be the only solution, and therefore the loans are destined to increase especially in the retail and SME segments, in our view (please refer to DenizBank Monthly December 2009 for more information). The funding side is strong both in deposits and foreign wholesale funding. 12 moths trailing foreign debt rollover ratio derived from the balance of payments fiigures points out that rollover ratio for the banks has bottomed out in August 2009 by 44%, and have been rising gradually since then. More importantly, the average rollover ratio of the last three months, September, October and November, is 138%. The deposit funding on the other hand is depicting even a more favorable picture. Surprisingly, 1050 bps rate cut did not mitigate TL preference of depositors. 2009 year end figures showed that deposits went up by 13.8% -compared to the 6.8% increase in loans-.

Jan-10

5.8%

3.2%

5.5%

3%

4%

5%

6%

7%

2005 2006 2007 2008 2009 2010

Figure 8: NPL Ratio

Figure 9: NPL Provision (Monthly)

100

300

500

700

900

1,100

1,300

Jan-07 Aug-07 Mar-08 Oct-08 May-09

(TL Mn. )

Average: TL0.3

bn

Average: TL0.8 bn

November = TL0.6 bn

74%

54%

0%

200%

400%

600%

Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09

Banks Firms

Figure10: 12M Trailing Foreign Debt Rollover

Ratios