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Turkey in 2008 and beyond: A perennial balancing act Looking for a bounce Arnab Das +44 (0)20 7475 3875 Head of EM.

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Presentation on theme: "Turkey in 2008 and beyond: A perennial balancing act Looking for a bounce Arnab Das +44 (0)20 7475 3875 Head of EM."— Presentation transcript:

1 Turkey in 2008 and beyond: A perennial balancing act Looking for a bounce Arnab Das +44 (0)20 7475 3875 Head of EM & FX Research Ivailo Vesselinov +44 (0)20 7475 4878 Senior EEMEA Economist Jon Harrison +44 (0)20 7475 4527 Head of EM Strategy Dmitry Sentchoukov +44 (0)20 7475 7895 Senior EM Credit/Equity Strategist

2 1 1 An Opening Gambit: Turkey’s future – still waiting for consensus? Turkey in 2008 and beyond: Looking for a bounce “One day my mortal body will turn to dust, but the Turkish Republic will stand forever” Mustafa Kemal Ataturk Turkey’s entry into the EU “…would be the End of Europe” Valery Giscard d’Estaing

3 2 Putting Turkey in its place: Global macro, EM, and domestic contexts ►Connecting the dots……………………………………………………………………………………………………………………………………..3 ►Anatomy of a Crisis: Housing bubble via securitisation and risk transfer to the destruction of financial capital and deleveraging ►Debunking De-/Re-coupling, Goldilocks, and other fairy tales on a stroll down memory lane…………………………………………....6 ►The United States as leading the global macro cycle, accompanying or preceding EU recessions and EM growth cycles ►Choosing words carefully: Rebalancing……………………………………………………………………………………………………………10 ►Already underway, and further to go ►Volatility – The name of the game: The world According to GARPI – our Global Aggregate Risk Perception Index…………….….14 ►Leading the US macro cycle; pointing to severe slowdown led by G10 financial systems credit, equity – but not commodities, EM ►Desperately Seeking Scenario Resolution…………………………………………………………………………………………………………17 ►How far, how fast will the United States slow; how will it hit the G10, and EM? ►The secular and cyclical EM backdrop ►The Turkey story: Looking for a bounce.....………………………………………………………………………………………………………..22 ►Surplus vs. Deficit currencies; inflation premia; credit and equity risks Turkey in 2008 and beyond: Looking for a bounce

4 3 Anatomy of a crisis, 1: Subprime Crisis becomes a Domino Effect Source: PIMCO JulyAugustSeptemberQ4 2007 ►Market shocked by 'unforseen' subprime defaults ►Widespread restatement of valuations of sub-prime related securitised financial instruments (CDOs etc) ►High-profile investor losses including within thought to be secure 'cash' funds ►Immediate withdrawal of investor risk appetite ►Credit risk re-priced with higher yield spreads ►Investors sell liquid assets MBS/IRS ►Initial credit concerns gave way to… ►Reduction in risk appetites ►Investors unwilling to participate in ABCP programmes… ►…creating demand for short-term financing ►Banks holding cash to support demand ►3-Month LIBOR pushed higher ►Impacting commercial and retail borrowing costs Subprime/Credit Crisis ►Liquidity shortfall continues… ►Banks still lending short- term, period rates elevated ►Credit conditions tighten for new borrowers ►ECB, Fed and (belatedly) BoE provide 'emergency' liquidity ►Fed eases rates 0.5% Liquidity Crisis ►Risk that money markets remain frozen… ►…high period rates ►Borrowers bear the burden ►Risk of a consumer led slowdown heighten ►Expectations for further Central Bank easing Credit & Liquidity Crisis Continues? Turkey in 2008 and beyond: Looking for a bounce

5 4 Anatomy of a crisis, 2: Housing crisis in metastasis across financial markets Mortgage Banks Banks Amortization Loan LBO/ Loan Corporate Institutional Investors Hedge Funds.... LBO/ Private Equity Loan Invest. in LBO Loan Interest/Amortization Securitization US Mortgage Market Invest. ABS Credit Enhancements Liquidity Lines etc. Investments ABS Private Equity Companies Credit- & Capital Market LBO/Private Equity Capital Market ABS ABCP CDO Source: Dresdner Kleinwort research Turkey in 2008 and beyond: Looking for a bounce

6 5 Anatomy of a crisis, 3: Liquidity and credit crunch trigger Central Bank Interventions A crisis of the global financial system emerged from the US subprime meltdown as liquidity proved to be the weak link… Bear Stearns Hedge Funds hit and bailed out Leveraged Loan worries emerge S&P MBS rating warning ABCP fail to roll IKB warning and bailout BNP Paribas freezes ABS fund; Countrywide Financial Warning ECB/Fed intervention Canadian CP liquidity squeeze Sachsen LB bailout The Fed has cut by 300bps since September 17 th Investment banks post further writedowns in Q4 Equity markets finally react Agencies start to downgrade US Subprime RMBS Moody's puts SIVs on watch ECB injects Funds BoE bails out Northern Rock Citi takes SIVs on B/S Fed & JP Morgan bail out Bear Stearns 50bps25bps 75bps50bps75bps BoE 25bp rate cut Turkey in 2008 and beyond: Looking for a bounce

7 6 The United States as the pro-cyclical country; euro zone as follower? 1. Three decades of recessions in the United States 2. Three decades of recessions in the European Economic & Monetary Union 3. Three decades of sequenced US/EMU Recessions ►Adverse global supply shocks precipitated coincident US/EU recessions (1970s) ►Adverse demand shocks: US recession first, EMU later (late 1980s: now?) ►EMU recessions have generally exceeded US recessions by a quarter or more… ►Has the world changed so much that trade and capital account exposure of the European Union to the United States will not suffer from the financial crisis in the latter? Does globalisation raise or reduce trade/financial linkages? Note: EU or EMU here consists of Eurozone members both since EMU and before Source: National Authorities; regional EU/CEPR studies; Dresdner Kleinwort Research Turkey in 2008 and beyond: Looking for a bounce

8 7 Globalisation and its regional discontents: US as pro-cyclical, EM as follower? EM Asia: Growth clearly hit by US/EMU recessions… EM Asia, ex-“Chindia”:…as well as regional financial turmoil LatAm: Heavily exposed to US growth, regional financial cycles ►History suggests neither EM Asia nor LatAm growth can remain insulated from a US recession … ►The demand channel – US and EU import demand in particular – are likely to be a key source of transmission ►EEMEA – led by the former Warsaw Pact – is ever more integrated into the G10, particularly the US-EU trade and financial nexus, so cannot remain insulated either Note: EEMEA considered on a country basis later given collapse of USSR and Warsaw Pact in 1989-91 Source: Dresdner Kleinwort Research using National Authorities’ data Turkey in 2008 and beyond: Looking for a bounce

9 8 Even the largest EM economies have not escaped US recessions… Turkey: Russia: Ukraine: Source: Dresdner Kleinwort Research using National Authorities’ data China: India: Korea: Brazil: Mexico: Argentina: Turkey in 2008 and beyond: Looking for a bounce

10 9 How different is it this time? Debunking decoupling: non-sense amid globalisation Bilateral trade deficits: Explosion of red ink on the balance sheet of the United States, spread liberally around the planet Source: US Census Bureau, Department of Commerce; National Authorities; Dresdner Kleinwort Research Turkey in 2008 and beyond: Looking for a bounce

11 10 Decoupling vs. Rebalancing: Slowing demand already curbing imbalances… Global macro imbalances have started to diminish even as US growth has slowed…and have further to fall with US GDP Source: Dresdner Kleinwort Research based on International Monetary Fund Turkey in 2008 and beyond: Looking for a bounce

12 11 But…The shifting sources of global growth given factor-price catch-up, PPP… EM, led by China, driving world growth 2004-08 (PPP GDP basis) Source: Dresdner Kleinwort Research based on International Monetary Fund Turkey in 2008 and beyond: Looking for a bounce

13 12 FX reserve accumulation: Proliferating, accelerating. And excessive? Source: Dresdner Kleinwort Research EM FX reserves skyrocketing, led by China and Russia – two countries with the major new sovereign wealth funds Turkey in 2008 and beyond: Looking for a bounce

14 13 Inflation surprising to the upside across EM, led by EM Asia, EEMEA Note: EEMEA comprises Russia, Turkey, South Africa, Central Europe. LatAm: Brazil, Mexico, Argentina, Colombia, Chile. EM Asia: China, India, South Korea, Thailand, Indonesia, Philippines, Singapore. Simple averages. Source: National Authorities’ inflation data; index of surprise indicators calculated by Dresdner Kleinwort Research Turkey in 2008 and beyond: Looking for a bounce

15 14 Dresdner Kleinwort Aggregate Risk Perception Index near all-time highs… Source: Dresdner Kleinwort Research ARPI off Bear Stearns-driven peak, but indexes of risk aversion and contagion remain high Turkey in 2008 and beyond: Looking for a bounce

16 15 …and ARPI points to significant slowdown in the United States and G10 Source: Dresdner Kleinwort Research Financial risk aversion (as measured by ARPI) coincides with severe deterioration in composite lead indicators Turkey in 2008 and beyond: Looking for a bounce

17 16 ARPI heightened by credit, equity, FX risks; and liquidity preferences Source: Dresdner Kleinwort Research Commodity and EM contribution to global Aggregate Risk Perception Index remains low Turkey in 2008 and beyond: Looking for a bounce

18 17 ►1. The United States flirts with but narrowly escapes recession. ►2. The United States faces a mild recession with manageable global costs. ►3. The United States suffers a typical recession with serious global costs. ►4. The United States enters a severe recession precipitating global slowdown. ►The United States leads the world into a protracted deflation (un-quantified). What matters for the global economy and markets, especially EM, is not whether the US enters technical recession, but how far, how fast, and for how long the US slows, and how this flows through the rest of the world. We model the path of the US, G10 and EM economies along the above four scenarios combining judgement and models Our scenarios and view that the joint probability of a severe recession or deflation is 15% or less reflect the political-economy of the United States. The federal democracy, where all politics is local, abhors a recession just as nature abhors a vacuum – it is driven by rules, checks and balances, states’ rights, and the interplay between executive branch and legislature. Labour markets, economy and financial system are highly flexible and responsive. Fed policy is subordinated to the triple mandate – price stability, full employment, modest long-term interest rates. Therefore, the Fed and the Treasury will do all they can to forestall or mitigate a recession, short of stoking high inflation. And so, we consider a slowdown with no recession; a mild recession, a “normal” recession, and a severe recession – all modelled on recent history. But we do not consider a 1930s- or Japan-style lost decade or depression with a protracted deflation. The United States is not Japan, nor are the 2000s the 1930s… but if such were to materialise, all bets would be off. What if? Modelling the reasonable… Thinking through the unthinkable We model 4 out of 5 potential scenarios for US macro performance, implications for the G10 and by extension for EM Turkey in 2008 and beyond: Looking for a bounce

19 18 Painting the picture: Global growth scenarios – US, G10, EM… 1. The United States just escapes recession 2. Mild Recession: Two quarters of negative growth Source: Dresdner Kleinwort Research 3. “Normal” Recession: Three quarters of negative growth 4. Severe Recession: Six quarters of negative growth Source: Dresdner Kleinwort Research Turkey in 2008 and beyond: Looking for a bounce

20 19 ►Dividing our World in Three: ►1. “G7 or G10” – high per-capita income, mature political systems, economies, financial markets: ►Unquestioned, continuous access to voluntary financing, based on policy credibility … ►High levels of savings, though with varied savings rates. Large, deep, liquid financial markets, with financial development driven by innovation. ►2. “EM countries” – mostly middle-income, high-growth, evolving political, economic, financial systems ►Still some risk of loss of access to voluntary capital markets, requiring occasional IMF programs (we hope) … ►Moderate to high levels of savings with varied savings rates. Experiencing fast financial deepening, largely adapting existing techniques to country-specific conditions. However, imbalances and inflation risks can disrupt markets. ► 3. “Developing countries” – low-income, still at risk of revolutionary political, economic, financial change: ►Limited access to voluntary capital markets; regular borrowers from IFIs; Paris Club governments. ►Movement across the 3 is a major global change, but cross-border flows are continuous and two-way: ►Private capital flows, of financial, technological, human/intellectual or luxury goods dominate the G7 to EM direction. Goods, services, people, and official financial flows dominate the EM to G7 direction. ►G7/G10 economic agents take EM exposure to acquire portable/portfolio alpha and/or beta. ►South Korea, new EU members are still in #2 “EM.” Though income is high and rising, markets are still evolving. ►New EU members will join #1 on EMU entry, acquiring major currency capital markets, bank reserves, and fiscal revenue, as well as policy credibility. Defining Emerging Markets: Countries, asset class/market segments Turkey in 2008 and beyond: Looking for a bounce

21 20 ParliamentaryPresidential UK/Canada US Germany/Italy France Australasia EM Asia Caribbean [British Colonies]EU Candidates/New Members Central Europe/Baltics Balkans Turkey? FSU Russia LatAm Ukraine? South Korea System of Government Totalitarian China …? Evolving EM political systems and their colonial progenitors/G7 models Appointed [USSR] 2005-07 Head of State “Constitutional” Monarch Indirectly-elected President Directly-elected President Head of Government Prime Minister President CabinetElected Appointed Appointed Prime Minister Appointed President EM G7 Political power Succession risk Japan Brazil Argentina Mexico Dispersed Low Venezuela? Concentrated High Central Bank Independent Subordinated India South Africa* *South Africa’s president is head of government and state, performing prime ministerial functions but is indirectly elected. 2002-? 1991-2000 Source: Dresdner Kleinwort Debt research Thailand? 2006-? Turkey in 2008 and beyond: Looking for a bounce

22 21 ►EM political systems are still evolving… ►… and, generally modelled on colonial or regional lines, despite what EM politicians may say about their unique political culture and history: ►The Former Soviet Union has moved from totalitarianism to a presidential/parliamentary mix (a la French Fifth Republic, but with considerably greater presidential powers in the CIS, with the Baltics following an EU model. ►Ukraine may be moving from a Russian to EU-style government. ►LatAm generally moved from totalitarianism to a US presidential model ►However, Mexico is liberalising. Argentina and Venezuela to differing degrees are concentrating power. Brazil’s coalition politics often requires parliamentary rather than presidential modus operandi. ►China is the elephant in the room: The Communist Party intends to retain a monopoly on power, but economic freedom and competition may prove incompatible with totalitarianism. ►And, political-economy is the crucial ingredient for macroeconomic management: ►A central G7/G10 vs. EM difference is the relative weight of institutions and personalities. ►Central Bank independence varies in practice, often regardless of de jure arrangements. ►Corporate governance challenges are qualitatively different in EM (about which more later). In EM, Politics determines everything else Turkey in 2008 and beyond: Looking for a bounce

23 22 2000 267 6.8 18.8 GDP (USD bn) GDP Growth (%) External Public Debt/GDP (%) B+/B1 Sovereign Rating, year-end 2003 324 5.3 21.0 B+/B1 2005 480 8.4 14.1 BB-/Ba3 2006 527 6.9 12.9 BB-/Ba3 2004 398 9.4 17.5 BB-/B1 2007 662 4.5 9.6 BB-/Ba3 LT Foreign Currency ratings GDP growth, % yoy Net FDI, US$bn Macroeconomic fundamentals have improved… Source: Ratings agencies, National authorities; Dresdner Kleinwort Research 2008E BB/Ba3 766 4.7 9.0 Turkey in 2008 and beyond: Looking for a bounce

24 23 …but “twin deficits” in the fiscal and current accounts persist 1. Fiscal Balance remains in the red… (TRY bn) is the Current Account balance (US$bn)… 4. Foreign reserves (US$bn) provide a cushion 3.... driven by a large oil bill boosting import growth. Source: Turkish Treasury, CBT, Dresdner Kleinwort Research Turkey in 2008 and beyond: Looking for a bounce

25 24 ►The fiscal parameters under the IMF standby arrangement program and active debt management have reduced public debt/GDP ratios, the nominal stock of debt, and the debt service burden. ►The public sector has continued to improve its net debt position, thanks to ongoing accumulation of central bank foreign assets and unemployment insurance funds. ►With sovereign debt diminishing, foreign investors have increasingly focussed on corporate/bank debt, equity, and local market instruments as alternative ways to benefit from Turkey’s improved economic prospects. Nonetheless, public debt has declined, crowding in corporate debt Total External Debt Stock (US$bn) Net public external debt (US$bn) Sovereign solvency and liquidity have continued to stabilise. Improved fiscal and debt management has helped to “crowd-in” corporates. Source: Turkish Treasury, Dresdner Kleinwort Research Turkey in 2008 and beyond: Looking for a bounce

26 25 Growing rich... But much still to be done… GDP per capita, US$ Source: TurkStat, IMD, Dresdner Kleinwort Research Industrial output – selected sectors, % yoy GDP breakdown by expenditure, % yoy Turkey in 2008 and beyond: Looking for a bounce Unemployment rate, % Annual standard deviations of quarterly GDP growth, % yoy GDP (2006), US$bn

27 26 Inflation and managing expectations still key challenges for the CBT CPI breakdown, contributions YTD % (March) Inflation and official targets, % yoy Turkey in 2008 and beyond: Looking for a bounce O/N and T-Bill rates, % NB. 2007 data for FCDs is through end-November. Source: Dresdner Kleinwort Research. Expected annual CPI in 12 months, %Expected annual CPI by year-end, %

28 27 Strategy: USD/TRY – Potential to reach USD/TRY 1.40 in coming months Global risk outlook does not favour the lira... ►Global risk appetite has improved in recent weeks but we caution that there are risks to come from the corporate sector and the real economy as well as the eventual impact of the US slowdown on growth in the Eurozone and emerging markets. ►The lira remains among the highest beta currencies in emerging markets (see later slide) and therefore among the most likely to weaken on any renewed downturn in global risk appetite. ►We expect the current account deficit to remain around 6% of GDP but this was less of an issue in 2007 given that 50% of the deficit was funded by FDI. This proportion could fall to 30% or lower this year increasing the vulnerability of the lira to any deterioration in the global risk environment. ►Turkey, in particular, has strong economic linkages with the Eurozone which is also a source of FDI and will therefore likely be impacted by the coming slowdown. Empirically we also find that the lira weakens versus USD when the EUR weakens (see later chart). We forecast EUR/USD 1.40 by end-2008. ►Turkey has among the highest policy rates among major emerging currency markets which we expect to help reduce the possibility of a significant lira depreciation. In 2006 the lira briefly fell to USD/TRY 1.70, but policy rates at that time were 13.25% compared with the current 15.25%. ►The long TRY vs short ZAR trade has been popular among emerging currency investors this year as a positive carry trade that provides some protection against the global risks that can hit currencies of countries with current account deficits. Positioning in this trade can provide some support for the lira. ►When considered on a purely risk adjusted basis – 3 month implied rates versus 3 month implied volatility - see later charts, we find that the lira is among the most attractive emerging currencies, again limiting extent of depreciation. ►We believe, however, that the current account deficit will result in a medium term depreciation trend while domestic politics presents a short term risk factor. ►In politics we expect tension in the AKP-secularist standoff to remain at an elevated level in the coming months. While worst case scenarios such as party closure may be avoided we caution that the combination of negative news flow, market pricing of extreme scenarios and the resulting stagnation of the reform process increases the near term vulnerability of the lira. Turkey in 2008 and beyond: Looking for a bounce... and domestic politics presents a near term risk

29 28 Short USD/TRY remains relatively attractive on a risk adjusted basis Risk adjusted returns Deficit currencies – return vs riskSurplus currencies – return vs risk Source: Dresdner Kleinwort Research ►Implied volatility has risen across all emerging currencies and in many cases increasing inflation risks have also resulted in higher short dated rates. ►We note, however, that in general rates have increased relatively more than implied volatility in currencies of countries with a current account surplus when compared with those of deficit countries. ►In the case of USD/TRY return versus risk has been on a declining trend over the past year, although has ticked up in recent weeks on heightened rate hike expectation. ►We consider here risk adjusted return as the ratio of 3 month implied FX yield to 3 month implied FX volatility. ►We find that despite the decline over the past year the expected return for a given level of risk for a short USD/TRY position remains the highest for any emerging currency. ►Whilst there are clearly many other factors to consider beyond simply implied risk adjusted returns, we believe that the attractiveness of short USD/TRY on this measure can help support the lira, relative to other vulnerable emerging currencies. Turkey in 2008 and beyond: Looking for a bounce

30 29 Return versus risk 3m implied FX yield net of funding / 3m implied volatility Source: Dresdner Kleinwort Research Turkey in 2008 and beyond: Looking for a bounce

31 30 Turkey - CDS and USD/TRY are still correlated Short USD/TRY versus buying CDS protection? ►We have previously recommended sovereign CDS as a hedge for FX positions - selling USD/TRY vs buying protection - both asset classes have often proved similarly vulnerable during periods of market disruption and the net short USD/TRY, long CDS position has historically had a positive carry. ►In our view, the major macro economic risk factors for Turkish markets are little changed in recent years, in so far as the following - ►Turkey remains a net external borrower so sovereign CDS spreads are generally more vulnerable than in markets with similar credit ratings where sovereigns are reducing net external debt. ►The persistent current account deficit suggests a medium term depreciation trend for the lira and it is therefore vulnerable when markets differentiate between the currencies of surplus and deficit countries. ►The lira and CDS have historically both been high beta compared with peers making them vulnerable to global and domestic news flow. Turkey in 2008 and beyond: Looking for a bounce

32 31 Turkey - CDS and USD/TRY (2) CDS has widened but USD/TRY has increased more Beta of CDS vs FX has declined sharplyCDS historical vol has remained relatively low Source: Dresdner Kleinwort Research Turkey in 2008 and beyond: Looking for a bounce Latest CDS vs FX moves: lira relatively weaker than CDS

33 32 EM FX betas – TRY among the most vulnerable to global risk aversion Calculating EM FX betas vs overall EM FX market EM FX beta vs market and range of beta over the past 3 months Source: Dresdner Kleinwort Research Turkey in 2008 and beyond: Looking for a bounce ►We calculate the betas (coefficients of the multiple-regression of daily changes) of each emerging currency relative the overall emerging currency market using our proprietary EM FX index. ►We find that the lira is consistently among the highest beta emerging currencies and in the current environment is also above the long term average in terms of relative reaction to changes in global risk appetite. EM FX index weights ►We calculate an index of emerging currencies. Our objective is to recognise the large and liquid markets that are important to EM FX investors without overweighting countries purely on the basis of large GDP, share of trade or large equity market cap. ►We allocate a maximum weight of 8% for major emerging currencies, 4% for second tier currencies and 0.2% for peripheral currencies with limited liquidity and small market size.

34 33 EM FX vs G3 FX betas – TRY set to weaken if EUR weakens Calculating EM FX betas vs G3 FX Coefficients (betas) of emerging currencies against USD, EUR and JPY (3m history) Source: Dresdner Kleinwort Research Turkey in 2008 and beyond: Looking for a bounce ►We calculate the betas (coefficients of the multiple-regression of daily changes) of each emerging currency with respect G3 currencies. This could be achieved consistently across G3 via a non-G3 cross rate such as CHF although in practice we use suitable random variable to eliminate individual currency bias. ►In the case of the lira we highlight not only the high beta status relative to G3 currency moves but specifically the dependency of TRY on EUR – the TRY is empirically among the most vulnerable currencies to a weaker EUR. ►For example, changes in G3/CHF (referred to as Δ [USD/CHF] etc.) have on average over the past 3 months been associated with changes in TRY/CHF in proportions: ►Δ [TRY/CHF] = 0.92 x Δ [USD/CHF] + 0.84 x Δ [EUR/CHF] - 1.27 x Δ [JPY/CHF] Interpretation of EM FX vs G3 betas

35 34 Turkey – Local fixed income still the long term convergence trade Inflation remains a risk in the coming months CPI has not yet decisively peakedInflation still surprising on the upside Source: Dresdner Kleinwort Research Turkey in 2008 and beyond: Looking for a bounce ►CPI inflation remains well above the long term 4% Central Bank target range and has not yet decisively resumed a downward path following the inflationary impact of the mid-2006 lira depreciation exacerbated by rising food and energy prices. ►We note, however, that inflation (CPI and PPI) has consistently surprised on the upside versus consensus forecasts in recent months raising concern that policy rates may have to increased before being cut. In any event, we expect the resumption of the easing cycle to be at least 3-6 months away and then only for rates to be cut gradually at first. Long term convergence trade ►The charts on the following page illustrate the local fixed income curve illustrating that over the past few months long dated rates have risen close to 2006 highs and that the curve is significantly less inverted than it has been in the past. ►We calculate, for example, that the local bond curve is implying 3 month T-bill yields still to be around 17% in 4-5 year’s time, close to current levels. ►In our view, the rates convergence trade remains a trade for later in 2008 and we expect to see dramatic curve inversion once the timing of aggressive rate cuts becomes more certain.

36 35 Turkey – Local fixed income still the long term convergence trade Implied path of 3m T-bills still far from pricing rate cuts High inflation priced into CPI linked debtTURKGB yields reaching mid-2006 highs Source: Dresdner Kleinwort Research Turkey in 2008 and beyond: Looking for a bounce TRY IRS curve potential to invert further

37 36 EM Credit Strategy - Global In 2007, fundamentals have taken the back seat … Deficit countries and oil importers outperformed …… on demand for their high yielding local debt Source: Dresdner Kleinwort Research ►The deficit countries (Turkey, South Africa) have outperformed surplus countries (Russia, Argentina) in the year when global liquidity crisis shook the globe and (at least in theory) made it harder for sovereigns to finance deficits. ►Oil importers (South Africa, Turkey) outperformed oil exporters (Russia, Kazakhstan, Venezuela) in a year when oil prices have risen by more than 60% briefly touching US$100 mark in January 2008. ►External debt of the deficit countries with high-yielding local markets (Turkey and South Africa) had outperformed due to indirect support from the rotation of client funds from EM hard currency funds to EM local currency funds ►CDS of the sovereigns with developed corporate bond markets (Russia, Kazakhstan) underperformed as investors were using relatively liquid sovereign CDS to hedge their corporate debt exposure. Turkey in 2008 and beyond: Looking for a bounce … as spreads were driven by technical factors

38 37 EM Credit Strategy - Global We continue to recommend Marketweight in EM credit: both sovereign and corporate ►We believe that the time for “it’s always darkest before dawn” opportunity to buy EM credit as an asset class has not come yet, but is closer than many investors think. ►The bailout of Bear Stearns creditors by the US Fed indicates that the worst in the systemic financial institutions’ liquidity crisis is behind us… ►… but the US recession (or near-recession) is still on the cards. The access to credit for households and corporates is likely to remain restrictive and, combined with high commodity prices, is putting further pressure on consumer spending. In turn, weak corporate results and rising US corporate default rates are likely to result in further widening of the US credit spreads… ►… but the bulk of EM credit universe comes from larger, commodity-exporting EM countries which are insulated by their high reserves and low debt, and fundamentally are better able to weather the US/EU slowdown. Consequently, since the beginning of the year, EM credit spreads have been less volatile than US corporate spreads ►We expect at least some of the misallocations of the “if you can’t sell what you want, you sell what you can” era to correct as a result of relative stability of spreads and renewed investor’s appetite. ►The success of the new Gazprom issue demonstrated that there is an ample demand for EM assets provided that the price is right. Moreover, subsequent tightening of Gazprom’s secondary market spreads showed that investors are often overcompensated for the supply risk. ►We expect this to trigger convergence between CIS and LATAM corporate spreads over time as the concerns about new supply were among the primary factors leading to underperformance of CIS corporates relative to their Latin America peers. Turkey in 2008 and beyond: Looking for a bounce

39 38 EM Credit Strategy - Turkey The shift towards fundamentals is already happening… EMMP country recommendations Source: JP Morgan, Dresdner Kleinwort Research ►We retain Turkey at Marketweight. ►We recommend Underweight in Mexico, Colombia and South Africa - the countries most exposed to the US slowdown. ►We recommend overweight in Russia and Brazil – low beta surplus commodity exporters ►Turkey: Retain at Marketweight: On a negative side, Turkey, a twin deficit country and the only sovereign in EM universe with substantial borrowing needs, remains vulnerable to the any further worsening of the primary market conditions. ►The country is among the most exposed to both high commodity prices (especially oil) and economic slowdown in the US/EU ►Finally, the country politics remains challenging as manifested by AKP-secularist standoff even though the worst case scenarios such as party closure may be avoided. ►On a more positive side, economic growth is continue albeit at a slower pace as are the FDI inflows. ►Turkish foreign exchange reserves are adequate and to date the country has shown a surprising ability to issue external debt despite challenging debt market environment Turkey in 2008 and beyond: Looking for a bounce … we recommend Marketweight in high yield countries

40 39 ►1. Employee/Management ►2. Creditor ►3. Tax Collector ►4. Shareholder in public or private equity (majority/minority) ►1. Majority Owner/Manager (state/family/entrepreneur/oligarch or private equity) ►2. Employee ►3. Creditor ►4. Minority Shareholder in public equity EM corporate governance: Qualitative differences between G7 and EM Hierarchy of stakeholders in stylised G7/G10 firm... …differs from the stylised EM firm ►The G7/G10 system depends on a solid wall between management and ownership to ensure an equitable distribution of returns as per the stylised, actual and contractual rules. ►This is the basis of G7 public equity, especially “Anglo-Saxon.” If rules are broken and culprits found, they are prosecuted and jailed; rules strengthened (Parmalat, WorldCom, Global Crossing; Sarbanes-Oxley). Incentive programs to align shareholder/management interests like stock options are a technique to achieve greater efficiency and returns for the shareholders – not to change this precedence of stakeholder claims. The choice of financing the G7 firm by debt or equity is not a systematic choice about equity or credit risk premium, but a name- or sector-specific choice. ►The state and the owner-managers of EM conglomerate/blue chips are often one and the same, or closely connected, contributing to episodes of privatisation and nationalisation, along with widespread fundamental information asymmetries. ►Shareholders are not created equal, nor are they equitably treated, nor do they all come at the back of the cue. In state-owned firms, the budget often takes out the upside in the form of dividends or windfall taxes, and often cushions the cost of bad decisions by hiding or socialising costs and losses in the budget. Similarly in majority-shareholder dominated and managed private conglomerates. Minority public equity holdings come at the back of the cue. Private equity is varied. Corporate credit and equity risk premia are therefore far apart, and equity becomes a viable option for financing the EM firm as the firm or country evolves. In the main, EM corporate credit and strategic equity/joint ventures or green-field/privatisation FDI dominate EM financing and technology transfer, rather than public equity. Turkey in 2008 and beyond: Looking for a bounce

41 40 2008 and beyond – Time to demonstrate resilience ►Cautious outlook for 2008 – gradual economic recovery. ►Activity set to be boosted by previous monetary easing... ►... but strong export growth could be threatened by uncertain outlook for the eurozone. ►Political pressures pose a risk to the fiscal performance... ►... which could hinder the central bank’s efforts to curb inflation. ►Central scenario – moderate acceleration in GDP growth in 2008, followed by return to trend in 2009. ►Medium-term challenges: CBT credibility gap over inflation, CA deficit, structural reforms, politics. ►Solution: Preserve political stability, stick to EU convergence path, structural reform to improve incentives, competitiveness; and reduce the economy’s vulnerability to external shocks, speculative investment flows, and commodity price fluctuations Turkey in 2008 and beyond: Looking for a bounce

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