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March, 2007

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Turkish Gold

by C. Hasan Umur

As Turkey continues to negotiate EU membership, TI examines the importance
of Oriental tobacco leaf to the nation’s economy.

Last year marked the beginning of a new era for Turkey’s membership in the European Union. After the official start of the accession negotiations in October 2005, the process has begun to reveal its politically dynamic nature in that ongoing policy and reactions to new developments affect the parties’ respective stance on the whole picture.

The first test came in 2006, when Turkey refused to change its policy of not allowing Greek Cypriot ships and planes to use Turkish seaports and airports. Turkey has always maintained that the full EU membership of Cyprus before reaching a final solution on the Cyprus issue was a fait accompli. On its side, the European Union is insisting that all its member states should have access to Turkish trade routes and, therefore, Greek Cypriot vessels should have access to Turkish ports. The stalemate that followed resulted in the EU’s suspension of eight of the 35 chapters of the accession talks between Turkey and the Union.

The events of 2006 hint at the difficulties Turkey and the EU are yet to face if the membership is to materialize. There are fundamental, though somewhat rhetorical, questions that need to be resolved, while the economic detail is diligently determined. One such fundamental point is Cyprus. Another is the religious unity of the European Union, as periodically implied by conservative leaders in some of the member countries.

What is clear is that the parties need to resolve the issues as and when they arise, instead of shelving them like they did in 2006. A progressive nature of the membership negotiations will benefit both Turkey and the European Union, as much as the membership itself finally will.

In 2006, the Turkish economy continued to perform well, as evidenced by the economic indicators announced by Prime Minister Recep Tayyip Erdogan in January 2007, as he prepares to launch his campaign for the general elections due to take place in autumn this year. The government is prudently following the austerity program put in place following the economic crisis of 2001, under the auspices of a three-year stand-by agreement with the IMF due to expire in early 2008. The program pursues a tight monetary policy aimed at reducing inflation, together with a reform of the banking system, increased privatization, and efforts to reduce the Public Sector Borrowing Requirement. The result, as outlined by Erdogan, is impressive indeed : As of Dec. 31, 2006, inflation remains (just) in single figures, the debt-to-GDP ratio is below 50%, and the budget deficit stands at 1% of GDP. All this is achieved with a real growth rate of over 5% for the fifth year in a row. (See Table 1.)

It’s the Economy
Where is the catch? The truth is that the economic theory of the 20th century is rendered obsolete by the ever-increasing global liquidity, and the transformation of the world’s capital markets from their previous national nature to a truly global scale. Macroeconomics dealt with assumptions within national boundaries; in “globeconomics,” there are just too many assumptions to be made and thus mathematical models predicting the future become almost impossible to build.

The strong Turkish lira (see Table 2), which is the main reason for the increase in the price of Turkish Oriental tobaccos over the last four years, is a case in point. The anchor of Turkey’s economic policy is the high real interest rate on the Turkish lira set by the Central Bank of Turkey. The nominal annual rate is nearly at 20%, which implies a real rate of 10% when inflation is deducted, and is simply the highest being paid among the countries with emerging market economies today. This policy is certainly the correct one for fighting inflation and for servicing the country’s punishing debt. However, such high interest rates would normally bring GDP growth to a grinding halt, if not cause a contraction of the economy. It is the international capital flows that allow for GDP growth in a high local currency interest rate environment by facilitating cheaper foreign currency financing for businesses.

The global liquidity is flowing into Turkey, attracted by the high interest rate. This in turn finances the debt service, the trade deficit, and local investment. There is, of course, a huge inherent currency risk, especially for businesses with lira revenues and foreign currency liabilities, but as long as the Turkish lira interest rate is so high, the risk is systematically postponed. That is, until such time that the global liquidity changes its risk-return preference, or seeks more exotic havens. This leads to the conclusion that exchange rate determination in today’s globeconomics assumes similarities with commodity pricing and therefore becomes cyclical in nature. During 2006, there was a significant outflow of short-term funds that resulted in a marked weakening of the currency in the months of May and June. However, the Central Bank swiftly hiked the interest rate, which lured the funds back and reinstated the strong Turkish lira.

The main victim of the economic policy is the trade deficit, which worsens with the strong currency. Imports continually gain a competitive edge over domestic goods, and exports, especially those like tobacco with input costs driven by the lira inflation, suffer a loss of competitiveness.

With the trade deficit exceeding US$50 bn for the first time in the country’s history (see Table 3), the export sector is more than ever preaching the need for a correction in the exchange rate. However, given the explanation of the new cyclical nature of exchange rate determination, a more prudent policy for exporters is to apply partial hedges on the exchange rate, following the movements in the cycle.

The Turkish Tobacco Situation
The Turkish Oriental tobacco production in the 2005 crop reached 129,049 tons, slightly above the production of the 2004 crop. In all regions, production figures were very similar to the previous year, reflecting a stability of the supply and demand balance. However, the Oriental crop calendar as it is traditionally structured requires planning for quantities up to 18 months prior to shipment and the effects of market conditions on the supply and demand balance tend to surface two crops into the future.

The green price in terms of U.S. dollars for the 2004 crop had been the highest in recent memory and similar price conditions prevailed in the market for the 2005 crop. High green prices coupled with a low yielding crop, especially in Izmir, to produce a high cost structure for the leaf and final export prices were once again higher than the previous crop.

The main reason for the high price is the effect of the strong exchange rate on input costs. The Turkish currency has appreciated against the basket of foreign currencies in real terms for the fifth year in a row, leading to an increasing trend in the cost structure.

In fact, the agriculture of tobacco in Turkey is still based on very sound fundamentals. Since the structural reforms to the tobacco market mechanism were implemented in 2002, tobacco in Turkey is grown without any subsidy or premium whatsoever, with quantities and pricing evolving under free market conditions. The advantage of the free market is that it encourages players to focus on improvement and innovation to counter the effects of monetary phenomena. Over the last three years, the leaf tobacco sector in Turkey has put in place many initiatives to improve the sustainability of the tobacco production. The shortening of the crop calendar, improvements in the curing and packaging of tobaccos at the farm level, and efforts to increase the optimum production amount per farmer are among the initiatives. These innovations will strengthen the position of Turkish tobaccos, especially when the monetary trends begin their inevitable reversal.

The 2006 Crop
The demand for the 2006 crop was adversely affected by the rising price trends and the overall stock situation for oriental tobacco. As a result, the total contract amounts were below the 2005 crop levels, especially for Izmir tobaccos. The total contracted amount for the Turkish oriental 2006 crop is 114,044 tons, with the expected actual outcome falling short of contracts by 15.4% to produce a crop of 96,500 tons. (See Tables 4 and 5.)

Tekel received official authorization to continue to contract tobaccos for the amounts that represent its own usage for cigarettes, and its presence in the market helped counter the decline in the export demand.

Izmir. The most significant decline in demand in the 2006 crop from 2005 was for the Izmir variety (see Table 6). The total amount of contracts for the 2006 crop was for 71,553 tons from 76,181 farmers, compared to 90,921 tons contracted from 95,940 farmers in the 2005 crop. Thus, the contract amount showed a decrease of 21.3% or nearly 20,000 tons. Dry weather conditions in the northern regions further contributed to a shortfall in the actual production, with the expected actual crop size standing at 56,000 tons, which is 21.7% short of the contract amount, and 32.9% lower than the production of the 2005 crop.

The 2006 Izmir crop size of 56,000 tons, the smallest in half a century, raises the question of a possible supply shortage in the future. To analyze the supply-and-demand balance, one approximation for the demand quantity is the total usage for the variety. The total usage can be estimated from the export quantities. In the calendar year 2005, 98,487 tons of Izmir tobacco were exported from Turkey. In the first seven months of 2006, the exports of Izmir were 51,030 tons, indicating a total estimated export quantity of 90,000 to 100,000 tons for the whole year. When the local usage (by Tekel and the private sector) is added to the export figures, a total annual Izmir usage of 110,000 tons is not improbable.

Based on this analysis, the 2006 crop size is only adequate to cover one half of the demand. However, the analysis is somewhat distorted because the export figures include sales of old crop tobaccos at lower prices, which may not be demanded from current crops given the high cost structure. Still, it can be concluded that the 2006 crop size for Izmir is too small and the market balance can be found between 70,000 tons and 85,000 tons, the exact level depending on the evolution of the cost cycle, which itself is primarily dependent on the exchange rate.

The quality of the Izmir 2006 crop is fairly good, and is superior to the historically poor 2005 crop. The weather conditions during transplantation and the land period differed within the region, with the northern (Classical) districts experiencing very dry conditions. The southern districts did receive rainfall in late May and the month of June, and the quality of the lower stalk in those districts suffered as a result. Overall, the yields for the top grades will be higher in the Izmir 2006 crop compared to the previous year.

Black Sea. Of the different Black Sea varieties, Samsun produced 11,000 tons in the 2006 Crop, Turkish Basma around 5,200 tons and other varieties 1,300 tons. (See Table 7.)

The Samsun 2006 crop is expected to materialize at 11,000 tons, falling short of the contract quantity by 11.7%. The quality is normal, with thinner low stalk due to early rains, but fairly good upper stalk. Yields should be along the lines of an average crop.

The Samsun variety has enjoyed a solid supply-and-demand balance over the last five years. An earlier decline of the production quantity, down from the 20,000-ton level in the 1990s, leveled out at around 10,000 tons in the 2000s where both production and usage appear to be sustainable. The farming community in Samsun is committed to tobacco production, and there may be room for the growth of the crop size with an increase in the optimum production quantity per farmer.

Turkish Basma production for 2006 is expected to be 5,200 tons, delivering more or less the same quantity as was contracted. Due to the geographical proximity, the Basma crop quality follows the same patterns as Samsun, and the 2006 crop is no exception, producing a good to average crop with weaker low stalk and successful top hands.

Of the three export varieties, the Turkish Basma is the one with the highest growth potential if there is an upward surge in demand. The region, though fairly small, is concentrated on tobacco production, and has historically produced crop sizes as high as 12,000 tons.

The Privatization of Tekel
After two previous unsuccessful attempts, the Finance Ministry announced that the privatization process of TEKEL would re-commence in February 2007. It was still unclear whether the third round would mirror the first two by putting the cigarette division on sale in its entirety or whether the company would be sold in parts by matching factories and brands. However, the Finance Ministry has recently declared that the privatization will be postponed again, to be reconsidered when Tekel achieves a stronger position in the market, in order to facilitate a higher value for the company. With two sets of elections scheduled in 2007, presidential in the spring and general in autumn, it seems that the earliest timing for the re-launching of the privatization process will be in early 2008.

Tobacco International - March, 2007

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