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Western EuropeOctober 3 2004

Domestic bonds look enticing

Investors are being tempted into the Turkish government bond market by transparency and accessible information about state borrowing, and by bond sellers confidence in the economy, says Nick Kochan.
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Bond salesmen in Turkey’s main banks are more confident about the prospects for Turkey’s economy than they have been for a long time. This feeds through into an enthusiasm for the Turkish domestic bond market.

Despite a backdrop of falling inflation and a primary surplus that looks sustainable, Turkey bonds are issued with yields of 25%, while inflation stands at 10%, making a 15% differential. This price is partly determined by the government’s need to keep the markets sweet so that they allow it to roll over most of its debt stock over the course of a year.

The transparency of government processes and the level of information that the Treasury provides about its borrowing plans are also making a good impression on players in the Turkish bond markets. Turkay Oktay, the general manager of AK Securities, says: “The government has auctions nearly every week. They announce their debt programme every quarter, and at the end of every month, they announce a monthly programme for debt borrowing. It is a regular business, there are no shocks or unexpected news.”

Turkey has to pay about TL52,000bn ($34.5m) in annual interest repayments, and is under great pressure to cut its interest rate bill. Local observers expect reductions in interest rates, if the government can fulfil its pledge to reduce inflation further and sustain the debt to gross national product ratio along Maastricht-compliant levels. The approach of the EU’s decision regarding Turkey’s long-standing membership application buoys local markets.

According to Guney Demir, a dealer in Turkish bonds at AK Securities: “We are borrowing overnight at a compound rate of 24.6% but the income we receive from bonds is over 26%. We are advising people to buy bonds on the basis of our strong hopes for eventual EU membership. We are feeling very positive about Turkey’s future.”

Market enthusiasm

Ahmet Erelcin, the general manager at HSBC in Istanbul, conveys the market’s enthusiasm for government policy. “There has been some concern about the sustainability of the domestic lending programme but we see no problems. As long as the primary surplus is maintained within acceptable levels, the domestic debt stock will continue to decline over coming years.

“We see fiscal discipline as of the utmost importance. So far, the government is quite sensitive to this threshold and the markets have responded. Turkey has reported a primary surplus over the last three years between 5% and 6.5% of gross domestic product (GDP) and, as a result, the debt to GDP ratio is declining. This is a healthy indication.”

A number of factors in bond issuance indicate the growing maturity of the local bond market. Most significantly, bond maturities and tenors are lengthening. Bond tenors fell to as low as nine months when the country was at the nadir of its economic crisis in 2001, and interest rates topped 100%. The corner of shrinking bond tenors has now been turned and the benchmark government bond has an 18-month tenor.

Longer tenors

The market looks forward to bond tenors stretching out to between two and four years in 2005, while the market’s most optimistic players believe a 30-year issue might be possible in the medium to long term.

“One of the government’s objectives, in addition to reducing the interest burden on the Treasury and the cost at which the Treasury borrows from the market, is to extend the maturity,” says Mahmut Kaya, executive vice-president for research at Garanti Securities. “Three years ago, the average maturity of domestic debt was under one year. It is now over one-and-a-half years and it is heading in the right direction.”

The benchmark deal used by the markets has a maturity of 534 days and a 25.40% interest rate, says Mr Demir.

A sharp dilemma presents itself to state Treasuries when interest rates are in sharp flux and economic indicators are broadly positive. This is the timing of changes to both interest rates and bond tenors. Turkey’s economic planners are seeking to make exactly this calculation, says Mr Kaya. The Turkish Treasury does not want to issue bonds with longer maturities too soon because it believes interest rates are declining and the government will be locked into a yield that may look retrospectively too high. On the other hand, the government can save money on borrowing by issuing bonds of longer maturities.

“If you believe that rates will be lower six months from today, then you would not want to extend the maturity. It means that you are borrowing today expensively. If you believe that rates will be lower in six months, then why lock yourself in at a higher cost for a longer maturity? It is a fine balance between the two,” says Mr Kaya.

International interest

While technical developments in bond supply suggest that the market outlook is favourable, elements on the demand side indicate new sources of interest in Turkish bonds. Foremost among these is a resurgent international participation in the Turkish markets. Bond purchasers from the Arab world, in particular, are buying Turkish bonds aiming to arbitrage differentials between local Turkish and international interest rates. This Middle Eastern interest coincides with Turkey’s bid to establish Istanbul as a centre for Islamic banking, alongside Bahrain and Dubai.

Turkish private citizens have also been tempted into local bond markets by a government offer of fiscal incentives. “The man on the street owns a lot more government bonds than he did three years ago,” says Mr Kaya. “The government has provided tax advantages for bond ownership. There is no withholding tax on government bonds and the returns up to a sizeable level are exempt from income taxation.

“For bank deposits, there is a highly demanding withholding tax of 10%-20% and it is not exempt from income tax. That has created a shift for retail investors from bank deposits to government bonds.”

The government’s history of stimulating its local bond markets with incentives for its private citizens and hefty margins for its professional and institutional investors has been criticised for crowding out other forms of bond issuance. For example, local banks complain that corporate bond issuance in Turkey is restricted, with banks preferring to borrow directly from banks rather than paying the intermediation costs involved in bond issuance.

Rising confidence

“Corporates are more eager to borrow over longer periods but the public is more eager to lend over the shorter term. So there is a maturity mismatch in demand and supply. Some of the withholding taxes make this instrument expensive compared to bank borrowing,” says Mr Erelcin.

Growing confidence in the stability of government economic policy promises not merely to encourage investment in government bonds, but also to broaden the debt markets. In due course, other products than government bonds will be developed, to the benefit of Turkey’s commercial and industrial sectors.

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