Turkey's yawning balance of payments deficit and an exodus of foreign investors suggest its unorthodox monetary policy experiment may have gone too far, threatening to make Ankara a new flashpoint for risk in global emerging markets.
The country's monthly foreign funding shortfall is running at almost $10 billion, latest data shows -- a tough position to be in when confidence in developing markets is shaky and Western powers are preparing to wind down easy-money policies.
Financing such a deficit in recent years hasn't been difficult, with Turkey's stock and bond markets pumped up by huge foreign portfolio flows, its 2001 financial crash a distant memory.
But that picture could be changing.
A Bank of America/Merrill Lynch poll last week showed equity fund managers are underweight in Turkey for the first time in more than three years. A separate JPMorgan survey showed foreigners cut Turkish debt and currency exposure in May and went significantly underweight on its bonds.
Non-residents had also pulled US$325 million out of Turkish stocks by mid-May this year, central bank data shows.
"There are very few countries in the world that run such a large current account deficit or are as vulnerable as Turkey to the withdrawal of capital from emerging markets," said Julian Thompson, head of emerging markets at Axa Investment Managers.
"It's sufficiently worrying to have next to no exposure there," added Thompson, who now has less than 1 per cent of the money he manages in Turkish stocks, versus 5 per cent last year.
The big issue for many foreigners is a central bank policy experiment that looks to have gone wrong.
In a bid to avoid currency overvaluation, Turkey's central bank six months ago shocked markets with an interest rate cut, arguing that this would drive out foreign hot money.
To check a domestic credit boom, it raised banks' required reserve ratios (RRRs), hoping this would cool the economy down.
Turkey wasn't alone in trying unusual measures -- central banks across the developing world used RRRs as a policy tightening tool after the so-called currency wars, that were triggered by a second bout of U.S. money printing last year.
But unlike Turkey, none went so far as to also cut rates.
"There are risks attached to this strategy because it's in unknown territory," said Pierre-Yves Bareau, head of emerging debt at JP Morgan Asset Management.
The steps did check lira gains. But by cutting rates the bank may well have reignited inflation in an already overheating economy as loan demand remains brisk. Lower rates also leave Turkey horribly exposed to downturns in global risk appetite.
At worst, Turkey risks a market meltdown followed by recession, harking back to its 20th century history of boom-and-bust economic cycles.
AXA's Thompson notes Turkish interest rates are half of Brazil's, yet it has a far greater deficit to fill.
"It's a dangerous game they are playing as the funding environment is becoming less favourable," he added.
The country's banks, which escaped the 2008 financial crisis unscathed, may also be at risk. Not only do they expect profits to take a 20 percent hit from the hikes in RRRs, there are signs they are turning to borrowing to meet unabated loan demand.
A BoA/Merrill client note estimated banks' short-term external debt at $50 billion, twice the pre-crisis peak.
All this has caused Turkish stocks and the lira to lag other emerging markets, with 9 per cent equity losses in May alone. Bond yields are up almost 200 basis points this year.
"We get the impression investors have lost patience with Turkey," said Michael Penn, global equity strategist at BoA/ML. "In many people's minds the policy experiment has failed."
Turkey's central bank has said that its steps have helped cut short-term flows and that it is optimistic credit growth will slow over time, but analysts now think it could find itself forced into a policy-tightening U-turn in coming months.
Foreign investors point to buoyant domestic demand fuelling relentless import growth and pushing the deficit ever wider. And nor are high oil prices entirely to blame -- non-energy items comprise almost half the deficit.
Investors also note other emerging central banks only used reserve ratios as a stopgap. JP Morgan's Bareau noted that all other RRR users followed up with fiscal tightening and rate rises. In this way countries such as China and Brazil have retained investor confidence -- the BoA/ML survey showed fund managers overweight in both these markets.
The consensus is that Turkey will eventually return to an orthodox monetary policy, probably once June elections are past.
Forward rates are pricing in 75-100 basis points in rate rises in 2011, while some like JP Morgan even predict 175 basis points in hikes as inflation expectations force a policy U-turn. Bareau conceded the central bank's current policy may yet work but he doesn't plan to stick around to find out. He sold his Turkish bond positions last week and is now underweight.