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February, 2008

SMOKE Magazine - Cigars, Pipes, and life's other desires

Turkey’s Oriental Leaf

By C. Hasan Umur

A snapshot of the Turkish oriental leaf market in a year of political drama, a mixed economic picture, and a continued lean towards global interdependency.

Last year was a year of heightened political activity in Turkey. Presidential elections were scheduled for April 2007, as President Ahmet Necdet Sezer’s term in office ended. The President does not carry executive power in Turkey, except for the right to veto, but is held in high esteem as a figurehead and the Head of State. The election is carried out by Parliament, with the nominee of the ruling political party usually winning the election, especially when the ruling party has a comfortable majority. The ruling conservative Justice and Development Party (“AKP”) nominated Foreign Minister Abdullah Gül as their candidate for the Presidency and the first round of the election was held in late April. However, members from the opposition social democratic Republican People’s Party (“CHP”) did not attend the session, and later petitioned the Constitutional Court, claiming that a two thirds majority was required to achieve quorum in Parliament for the session to elect the President. The Court ruled in favor of CHP, implying that the prevailing parliamentary arithmetic would not permit the election of Mr. Gül to the Presidency, given CHP’s clear opposition to Mr. Gül’s candidacy. This prompted AKP to dissolve Parliament and call general elections.

The general elections were held in July. AKP, led by Prime Minister Recep Tayyip Erdogan won a second term in office with a resounding victory, getting 47% of the votes casted. AKP promptly nominated Mr. Gül as their Presidential candidate again, and thanks to an understanding with the National Movement Party (“MHP”), AKP achieved the two thirds majority in attendance in Parliament for the election session, and Mr. Gül finally became the Republic’s 11th President.

In retrospect, the rhetoric that surrounded the presidential elections cost the country valuable time and forged a polarization between the secular sections of the population and the more conservative religious groups which, until then, had not surfaced so vividly.

Turkey’s economy had a mixed year in 2007. The inflation rate was more than double the targeted 4%; the rate of growth showed a marked slowing down from the 2002-06 annual average of 7.5%; and the Turkish lira continued to appreciate against major currencies, significantly impairing the competitiveness of domestic production.

The five years following the economic crisis of 2001 set the stage for a flourishing economy in Turkey, aided by the continuous increase of liquidity in world markets. We coined the term “globeconomics” in these pages in 2007. In the 2002-06 period, the Turkish economy benefited fully from globeconomics, in that a tight monetary policy could be pursued to combat inflation, while high growth rates could be achieved as investment was financed by foreign capital inflows at lower cost. In other words, the punishingly high real interest rate policy of the Central Bank did not have the classical macroeconomic effect of reducing demand, as credit was, and to a certain extent still is, available in foreign currency at much lower rates. Thus, high growth and declining inflation were achieved for five years.

The problem with globeconomics lies in its irreversibility. When world trends become unfavorable, it is almost impossible to control the national economy by macroeconomic policy alone, and previous gains can easily be lost. The tightening of worldwide liquidity following the sub-prime mortgage crisis is a case in point. At the onset of 2008, Turkey is faced with the continued necessity to keep interest rates high as inflation is far from being at the desired level, but foreign funds are not as abundant as before to continue fuelling growth. The economy inevitably slows down, with a grossly overvalued exchange rate into the bargain.

As a result, the trade deficit continued to worsen in 2007, exceeding 60 bn US dollars, and though not alarmingly high as a percentage of GNP, it still puts a significant financing burden on the country’s already debt-ridden balance sheet.

Even though the exports in terms of dollars rose by 25.3% in 2007, the increase is somewhat misleading as the dollar figure is inflated by the weakness of the dollar itself. The actual tonnage exported rose by only 13%, and with the anticipated shrinkage in global demand as a result of the infamous “recession,” the trade figures are expected to worsen in 2008 especially if the currency remains strong.

The economic policymakers, and specifically the Chairman of the Central Bank of Turkey, are therefore at a historic crossroads. The key issue is whether or not to decrease interest rates. A substantial decrease in the Turkish lira interest rate will facilitate a boost for domestic demand, increase competitiveness of domestic goods as a weakening of the lira will follow, and create a more favorable investment environment. Such a move will be a bold attempt to re-establish the might of macroeconomic policymaking over globeconomics. The catch is that the Turkish private sector is heavily exposed to currency risk and the withdrawal of short-term foreign capital will put a huge burden on companies’ balance sheets, and the ensuing turmoil in the market may be uncontrollable. Furthermore, a decrease in interest rates will increase inflationary pressure. At any event, this decade promises to add a chapter to textbooks on emerging market economics.

The Turkish Tobacco Situation
Tobacco production in Turkey is suffering from the strong exchange rate phenomenon, similar to other export goods and commodities produced in the country. The government’s economic policy puts emphasis on industrial growth, channeling resources away from agriculture into technology and services. The share of agriculture in the country’s GDP declined from 40% in 1960, to 16% in 1998, to 11% in 2007. Agricultural subsidies are negligible and the supply and demand balance of farm produce is largely left to the forces of the free market. Input costs are increasing by at least as much as inflation which implies spiraling prices in terms of foreign currency in the face of the strong exchange rate.

After two relatively stable crops in 2004 and 2005, the production of Turkish oriental tobacco fell by 27.8% to 93,240 tons in the 2006 crop. This was the first time that the production fell short of 100,000 tons in over half a century. The 2007 crop is expected to materialize at only 79,000 tons, registering a further fall of 15.3%. Both the decreases from 2005 to 2006 and from 2006 to 2007 were mainly caused by falls in the Aegean region which produces the Izmir variety. As Izmir is traditionally the locomotive for tobacco exports from Turkey, the decline in production causes concern regarding the sustainability of the crop.

The reasons behind the decrease in the crop size for two years in a row were in fact very different for the 2006 and 2007 crops. For the 2006 crop, the fall in production was largely demand driven in that suppliers did not contract for speculative quantities in the face of rising prices and in order to adjust their stocks, while TEKEL reduced its contract quantities to match decreasing usage. However, the actual amount produced in 2006, especially in Izmir, was even shorter than the downwardly adjusted contract volumes because the supply overreacted to the decrease in demand, thus creating a shortage. Coupled with the strong exchange rate, this led to a further increase in export prices. The shortage was largely overcome by an acceleration of movement of old crop stocks, both from suppliers and TEKEL.

The 2007 crop
Following the shortage in the 2006 crop production, demand from suppliers for contracts came back strong for the 2007 crop, and the contracted amounts were above the previous crop levels. However, the marked decrease in the number of farmers from 2005 to 2006 was not recovered. In Izmir, 95,940 farmers had contracted for the 2005 crop, reduced to 76,183 in the 2006 crop, and to 66,770 in the 2007 crop.

The Izmir 2007 crop fell short of the contracted amount by 45.9%, producing the smallest crop since the Second World War at 40,000 tons. The quality of the crop is fairly good, with mature and bodied top stalk, but the medium and lower stalk positions have suffered from the unusually hot summer, showing over-ripeness in the early planted lots and immaturity in the late planted.

The reason for the shortfall was the weather conditions prevailing during the growing season. Western Anatolia comprising the Aegean region experienced the worst drought in as many years, starting from the winter months of 2007 and lasting until fall. Many farmers had difficulty transplanting seedlings into the fields and those who succeeded subsequently faced historically low yields. The Izmir 2007 crop yielded less than 500 kilos per hectare compared to the previous five-year average of 750 kilos.

Whatever the reason, a 40,000 ton Izmir crop must initiate a serious new approach to the planning of crop production and to the improvement of agricultural practices in order to avoid a repetition of the shortage and to demonstrate to the world at large that the crop is sustainable.

For the last three years, annual exports of Izmir tobacco, old crop and new, have been around 100,000 tons. Discounting opportunity purchases, an estimate of potential demand for Izmir is around 70,000 tons which is significantly higher than the current crop production. Given, with normal weather conditions and applying average historical yields to the area planted, the Izmir crop could have been around 55,000 to 60,000 tons in 2007. Still, in order to maintain the critical mass of the crop and to retain the demand, Izmir must produce a convincing crop size in 2008 of at least 60,000 tons.

The leaf tobacco industry is well aware of the urgency, and is making a concerted effort to assure sustainability. Deliveries of the 2007 crop started in January 2008, two months earlier than had been the norm, thus giving the farmers the essential cash flow in time for the next growing season. There is considerable work on improving agricultural practices and to increase the optimum production size per farm. Furthermore, all agricultural products suffered from the drought in 2007, in most instances worse than tobacco. As a result, the tendency in the Izmir farming community is to stay with tobacco for the 2008 crop. With normal weather conditions in 2008, the leaf industry should get the turnaround of the Izmir crop that it has been expecting.

Black Sea
In contrast to Izmir, the Black Sea production of Samsun and Basma tobaccos has been the bastion of stability in recent years. After the structural reforms to the tobacco market mechanism implemented in 2002, Samsun production fell to the 10,000 ton level, where it has remained ever since. Demand has matched this supply level, making Samsun the most sustainable of export varieties.

The Black Sea region, which is situated on the northeast of Turkey, escaped the drought that plagued the west of the country and had favorable growing conditions for tobacco. Of the different Black Sea varieties, Samsun produced 10,000 tons in the 2007 crop, “Turkish Basma” around 3,800 tons and other varieties 1,200 tons.

The Samsun 2007 crop is of good quality, with very successful middle and upper stalks. As in most years, there is some second growth representing around 5% of the crop, which will find a place in the lower grades.

Like Samsun, the Basma region also had favorable weather conditions for the 2007 crop, producing a good quality crop which can be regarded as well above average with small leaf size and good maturity.

The Privatization of TEKEL
Turkish government’s third attempt to privatize TEKEL will take place later this month, with the deadline for the first round of bidding set for February 18, 2008. According to the Privatization Authority, there is considerable interest to purchase TEKEL this time around, both from players within the tobacco industry and institutional investors. The privatization is again structured as an “asset sale,” including the five cigarette factories and the cigarette brands. The assets will be sold as a package and will not be broken down for the purpose of the privatization. However, in the event that an institutional investor is successful in the tender, it may choose to later divest the assets part by part.

Tobacco International - February, 2008

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