Can Small Remain Beautiful?
Mar 08, 2006
Serhan Cevik (from Frankfurt)
Macroeconomic normalisation has exposed structural weaknesses in the corporate sector. Political and macroeconomic instability had distorted Turkey’s economic structure, but also produced an effect of a dark cloud covering inefficiencies in the business sector. In an environment shaped by high and volatile inflation and ever-increasing dollarisation, consumers lost the sense of relative prices and firms, especially those enjoying oligopolistic powers, could afford raising prices without paying any attention to operational productivity. It was not a sustainable ‘equilibrium’ but consumers hedged against inflationary shocks by dollarising assets and income streams and companies had become hedge funds investing in government bonds. As a result, the 1990s turned into a ‘lost decade’ during which the distribution of income and wealth worsened and non-financial companies started earning more than two-thirds of their income from financial transactions. Fortunately, or unfortunately, depending on your point of view, the 2001 recession cracked this vicious circle. It was a painful experience, but led to a mentality shift among politicians as well as consumers and the corporate sector. And, with the introduction of prudent policies and structural reforms, the Turkish economy has started moving towards a ‘normal’ equilibrium that now exposes micro-level weaknesses.
Institutional obstacles lead to sub-optimal distribution of resources. Turkey has enjoyed a spectacular normalisation, but there is nothing spectacular about being normal. This is why we have argued that microeconomic issues will become far more critical once the stimulus of macroeconomic normalisation starts fading out. In other words, the sustainability of economic growth will increasingly depend on the strength and agility of Turkey’s private sector, not just on the state of its public sector. And this is exactly where the country is having difficulties. Take, for example, per capita capital stock that is barely 30% of the OECD average and the technological renewal ratio that stands at 35% among manufacturing firms. In our view, these mediocre measures mainly expose the underperformance of small firms that account for more than 75% of employment, but generate only 27% of valued-added and less than 10% of exports. Such a distorted structure is, without doubt, a result of economic instability, but also reflects the state-centric development model promoting irrationally-diversified conglomerates and depressing entrepreneurial activity. Small and medium-sized enterprises are struggling to weather competitive pressures. Lots of small and medium-sized companies that give the economy its ‘flexibility and dynamism’ are actually undercapitalised and ill-equipped in terms of managerial and technological capabilities. According to the latest survey of corporate balance sheets, small companies have significantly lower profitability ratios in absolute terms as well as compared to large enterprises. For example, the average return on equity and assets among small firms were -1.0% and -0.5%, respectively, in 2004, compared to 2.4% and 4.7% for medium-sized enterprises and 6.3% and 11.7% among large companies that in fact generate the great majority of Turkish exports. Structural rigidities and technological sclerosis lead to lower productivity and higher labour costs. The latest figures clearly show that small and medium-sized firms have failed to cut costs, improve productivity and earn an adequate return on capital, especially, vis-à-vis the risk-free rate. We think that productivity differences — partly reflecting ownership structure and access to financial resources — are the key factor affecting profitability. Indeed, there is a robust link between firm size and technology-intensive capital spending, which in turn explains productivity divergences. The technological renewal ratio increases from 31.2% among small firms to 46.2% for medium-sized enterprises and to 56.3% for companies with more than 250 workers. Consequently, small and medium-sized firms have lower productivity and thereby face much higher unit labour costs. In our view, this awkward structure of inefficient suppliers explains changes in the composition of industrial production and the continuing increase in imports of intermediate goods. For small to remain beautiful, Turkey needs a rethinking of its development model. The lira’s strength may have a disproportionately negative effect on small businesses, but currency manipulations cannot bring financial improvements. The profitability deterioration is a result of structural weaknesses and therefore Turkey needs institutional and economic reforms to rejuvenate small firms. First, labour-intensive sectors struggle with higher labour costs stemming from above-inflation increases in the minimum wage and the distortionary tax regime imposing one of the highest employment tax rates in the world. Second, Turkey scores the worst (among OECD countries) in terms to secondary and tertiary education. Third, policies provide little incentive for modernisation and developing proprietary processes, technologies and brands. In other words, the authorities need to look beyond maintaining macroeconomic stability and introduce a more appropriate set of policies that would create a business-friendly operating environment. Having said that, putting all the responsibility on the government would be a big mistake, since it is ultimately up to the private sector to move up on the value-added chain and remain ‘beautiful’.
Important Disclosure Information at the end of this Forum
The Abundance Upgrade
Mar 08, 2006
Heloisa Marone (New York) and Franklin Adatsi (New York)
There was little surprise on February 28 when Standard and Poor’s upgraded its rating of Brazil’s foreign currency sovereign debt moving it from BB- to BB, now just two notches below investment grade status. After all, Brazil has been using its current abundance to eliminate its net external obligations first by building up reserves and more recently by buying back external debt (see “Brazil: Abundance is Just Beginning” in GEF, February 14, 2006). We expect that during the course of this year, perhaps as early as mid-year Brazil could have zero net external public debt (net of international reserves). The move has, as expected, raised questions over how close Brazil is to achieving investment grade status. Given the pace at which Brazil is extinguishing its net external public debt, an upgrade from Moody’s (currently at Ba3) to bring it in line with Standard and Poor’s latest move seems likely in the near term. And another upgrade to BB+ status could take place as early as next year or so Standard and Poor’s seemed to suggest when it noted last week that “a track-record of prudent fiscal policy through another electoral cycle” would likely generate “positive implications” for creditworthiness. In our first attempt to build a road map to investment grade status, we thought it would useful to take two approaches: first a look at the credit statistics to compare Brazil with investment grade countries, and second, to look at the average length of time seen in upgrades. Both suggest that investment grade is still at least two years away. Ultimately, the timing is not of paramount importance. What we will be watching for is how Brazil deals with the coming lower real yields to extend duration of its domestic debt, boost public investment and reduce its tax burden. Radar Road Map Brazil has made significant improvements in key solvency and liquidity ratios over the last four years relative to the investment grade benchmark (BBB-). Over this period, Brazil has moved up two notches (from B2 to Ba3 by Moody’s and from B+ to BB by Standard and Poor’s). While there have been notable improvements in external debt ratios, inflation, budget balance/GDP and reserves/short term debt ratios, other development areas such as growth, and the ratio of FDI to GDP have either moderately deteriorated or stagnated relative to the investment grade benchmark. Our latest reading of a set of solvency indicators suggests that Brazil is steadily approaching the investment grade threshold but there are still some challenges ahead. In particular, we identify three areas where Brazil still needs to improve: the external debt to exports ratio, the debt service to exports ratio, and the long-term GDP growth rate. We have focused on the solvency indicators, seen on the right hand side of the radar graph, in part because they tend to be more highly correlated with ratings. Brazil’s current external debt to exports (includes exports of goods, services and income receipts) ratio is around 133%, or less than one standard deviation (0.72) from the predicted ratio for BBB- countries (101%) and less than a third of a standard deviation from the predicted ratio for BB countries (124%). Brazil’s external debt to exports ratio has fallen by roughly one-third between September 2004 (192%) when Brazil received the last upgrade from Standard and Poor’s to BB- and December 2005. (Moody’s moved Brazil to BB- equivalent, Ba3 thirteen months later in October 2005). A breakdown of this analysis, however, points out to a delicate reality: despite the significant drop in total external debt, the strong growth in global appetite for Brazilian exports appears to have been the main driver for the declining trend in the external debt to exports ratio. While the total annual export value increased by over 30%, from $106 billion to $138 billion, between September 2004 and December 2005, the total (public and private) outstanding external debt dropped by 9%, from $202 billion to what we estimate around $184 billion in December 2005. Furthermore, the bulk of the improvement in external debt appears to have happened in late 2005 – exactly when the central bank initiated its aggressive buying spree. According to our estimates, the outstanding external debt would have to drop by at least another 14% from the current level, in order for Brazil’s external debt to export ratio to become less than a third of a standard deviation away from the BBB- predicted ratio. That would take about one and a half years if Brazil continues its public external debt management plan at last year’s “pace” and if export levels remain unchanged, which seems unlikely given the strength of the real. This analysis, however, does not take into consideration the fact that there have been changes in the quality of outstanding debt. Indeed, the debt management plan recently announced by the government includes short-term external debt buyback, the extension of the maturity of the debt and the substitution of floating for fixed rate. That in turn should help lower vulnerability to short-term interest and exchange rates fluctuations and decrease risk perception. Lower risk perception should in turn help to decrease the debt service that is around $50.3 billion, or around 38% of total exports as of December 2005, 9% lower than it was in December 2004 just after the Standard and Poor’s previous upgrade. Our computations suggest that debt service would have to decrease by another 10% from the current level in order for Brazil to stand as close to the BBB- level as it currently stands from the BB level in our radar chart. That would take roughly another year if the improvement were similar to what was seen last year (and exports were maintained). Of course, a period of lower interest rates projected for 2006 could reduce the length but could be offset somewhat by a more subdued export picture. On the growth front, Brazil would need an average growth of at least 3.6% in 2006 in order for Brazil to get as close to the BBB- as it is from the BB 5-year average growth level. Although we still believe that Brazil needs a significantly higher growth rate, it does not strictly speaking appear to be a serious impediment to a higher rating. The timing question Although the best way to measure Brazil’s proximity to investment grade status is to monitor its creditworthiness, we could not resist looking to see if there were any patterns in terms of the pace of rating upgrades. What we discovered after a review of thirty sovereign credits is that the closer the move to investment grade, the longer it takes to get an upgrade. The relationship was strongest with S&P where the average waiting time to an upgrade to the next level appears to increase as the credit approaches investment grade. Hence it took 22 months on average when 3 notches below investment grade, but 30 months when 1 or 2 notches below investment grade for a positive rating change for S&P credits. It was harder to discern any pattern within Moody’s, although the average for both agencies was around 38 months to move from BB (where Brazil is today) to BB+ and 27 months to move from BB+ to investment grade of BBB-. Oddly enough, the data suggest that the level of the outlook, “stable” or “positive,” does not seem to influence the likelihood of an upgrade. We warn against reading too much into the averages. Indeed, they would not have served a Brazil watcher well in recent years. Brazil waited only 17 months between its last upgrade by S&P from BB- to BB and from only 13 months from its last upgrade by Moody’s from B1 to Ba3. Still the averages are consistent with our credit analysis that investment grade would be unlikely before 2008 at the earliest. Bottom line The good news in Brazil is that the authorities are using the current abundance to eliminate the country’s net public external obligations both by building up reserves and buying back external debt. That in turn, along with its policies of extending duration and maturity of domestic debt and using monetary policy to help squeeze out residual inflationary expectations should help pave the way for substantially lower real yields. For Brazil’s fiscal authorities, the test of abundance is just beginning. How they deal with the abundance will ultimately determine Brazil’s ascension to investment grade status.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International Limited and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Dean Witter Asia Limited and/or Morgan Stanley Dean Witter Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley & Co. International Limited, Taipei Branch and/or Morgan Stanley & Co International Limited, Seoul Branch, and/or Morgan Stanley Dean Witter Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").
Global Research
Conflict Management Policy
This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.
Important Disclosures
This report does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: This publication is distributed by Morgan Stanley & Co. International Limited, Taipei Branch; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Dean Witter Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc., which accept responsibility for its contents. Morgan Stanley & Co. International Limited, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International Limited representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.
Trademarks and service marks herein are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. This report or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request.
|
