Barring a last-minute crisis, the Council of Ministers of the European Union appears likely to invite Turkey to begin membership negotiations in 2005 after its summit meeting this December. The European Commission's explicit positive recommendation and the acknowledgement in an annual progress report that Turkey has achieved the required threshold to meet the 1993 Copenhagen political criteria reduces the ability of the more reluctant EU members to base their opposition to the launch of talks on technical grounds.

There should be no illusions, however. Turkey's accession negotiations are expected to be long, nonlinear and open-ended, due to continued fears across Europe about admitting a poor, populous, Muslim country. This process will nonetheless provide an anchor for Turkey to stabilize its economy and attract much-needed foreign investment.

The development of a robust and modern banking sector is essential for Turkey to ensure capital formation to create the basis for sustainable financial stability and long-term economic growth--all necessary preconditions for Turkish membership in the EU. This will help reduce systemic risks in the financial sector and prevent a repeat of the 2001 financial crisis, the trigger of which was the fragility of the banking system. The 2001 crisis resulted in a 7.5 percent contraction of the economy, the worst economic crisis in the nation's history. A robust banking sector will also improve access to a wide range of modern financial products and services, including supply capital and credit, for the manufacturing sector as well as small and medium enterprises and low-income earners.

The opening of talks with the EU will be a significant opportunity for Turkey's banking sector in the next few years, as the prospect of EU membership negotiations has increased European interest in Turkey's banks. Although no deals have gone through so far, the accession process will raise European interest in the Turkish banking sector and may lead to major mergers and acquisitions. If talks begin as expected, the next three years will bring significant changes in both the ownership and asset structures of the banks as Turkey stabilizes its economy and continues its path toward converging with EU standards. The Justice and Development Party (AKP) government is currently in negotiations with the International Monetary Fund (IMF) on a new economic program, which would also serve as an economic recipe to bring Turkey's economy into closer compliance with the Maastricht criteria.

The AKP government's commitment to increasing regulation in the banking sector and implementing the current IMF-backed economic program--to be replaced by a new three-year stand-by agreement by the end of 2004--has benefited the Turkish banking sector. The market's confidence in the government's overwhelming strength in the parliament and its commitment to reform led to a substantial decline in interest rates and strengthened domestic currency, leading to a virtuous cycle in the financial markets. Despite pressure from its low-income constituency to boost public investments, the government appears to have recognized the need for continued fiscal consolidation to reduce Turkey's massive debt--now at about 70 percent of GDP--and maintain sustainable growth in the long run.

The Turkish banking sector has undergone substantial reform over the past four years. More rigorous monitoring and auditing procedures have been instituted for private sector banks with the establishment of the Banking Regulation and Supervision Agency (BRSA) in 2000. In order to remove weak banks from the system, the authorities encouraged consolidation and threatened nationalization of banks that do not meet minimum capital-reserve thresholds. The BRSA eliminated some 21 insolvent banks, while public banks began offering market interest rates, helping Turkey's major private banks that are more financially sound to increase market share on foreign exchange as well as local currency deposits.

The private banking system also benefited from the country's impressive performance in macroeconomic stabilization, as this has encouraged foreign capital inflow as well as the transfer of domestic savings out from underneath people's mattresses and into the banking system. GDP growth was reasonably strong despite the severe constraints on government spending, and it is expected to reach 7.5 percent for 2004 on the strength of increased private investment and consumption. The AKP government successfully continued its anti-inflation program, and consumer surveys anticipate year-on-year consumer price inflation to fall to approximately 9.5 percent by the end of 2004, down from about 30 percent two years earlier--and below the government's original target of 12 percent.

The strength of the Turkish lira has increased the weight of the lira-based equity accounts in the balance sheets of the banks, strengthening capital adequacy ratios. The banks enjoyed huge windfall gains on their sizable government bond portfolios as interest rates declined from levels around 65 percent in the first quarter of 2003 to 22 percent by October 2004. Financial consolidation, alongside increased productivity, allowed the banks to start allocating an increasing portion of their growing asset bases away from the bond portfolios and into higher-risk retail banking products such as consumer lending and credit cards, contributing to the country's impressive growth performance in 2004, expected to come in at around 10 percent.

The banks are by no means out of the woods. They remain vulnerable to a potential crisis that may change the macroeconomic environment, as the share of government bond portfolios in overall assets (for example, Akbank, Turkey's largest, has 50 percent of assets invested in bonds) exposes the banks to potential interest rate fluctuations and exchange rate volatility. The scarcity of free equity remains a critical concern for the long-term profitability of Turkish banks in a low-inflation environment. The analysis of the first-quarter 2004 sector data shows that while Turkish banking assets have reached $195 billion, 49 percent of the sector's equity has been locked up in property investments and shares in other companies (for example, Yapi Kredi's participation in cellular operator Turkcell).

The possibility of a smooth consolidation process through injection of the existing shareholders' sizeable capital into the Turkish banks or voluntary mergers among the existing players looks remote, however. The possible opening of EU accession negotiations in 2005, in this sense, may increase appetite among international banks to buy market share in Turkish banking and may facilitate fresh equity injection through mergers and acquisitions. Among the local banks, only Akbank seems fit to be a potential acquirer given that the size of its free equity exceeds $3 billion, indicating the critical importance of foreign interest for the sector to maintain sustainable growth and reduce its vulnerability to interest and exchange rate fluctuations.

So far, there has been an increased appetite from international giants to enter Turkish banking, but no large-scale deals have gone through. The investments of the early entrants such as British HSBC, which acquired Demirbank, and Italian Unicredito, which signed a 50-50 partnership with Kocbank, have remained relatively small, with market shares in total banking assets at 1 percent and 3 percent, respectively. The recent failure of Italian Banca Intesa and Dogus Group negotiations for the sale of the majority stake in Garanti Bank (due to disagreements on the share purchase agreement) eliminated hopes that such a large-scale deal would encourage further interest in the banking sector. There are indications, however, that international interest will increase in the next few years.

Regardless, Garanti Bank will maintain its place as one of the top acquisition targets for a potential entrant to the Turkish market, although the break-up of the Banca Intesa talks may have delayed its strategic sale prospects. Meanwhile, the state-owned Vakifbank, which yielded a $159 million net profit in 2003, awaits privatization in 2005. teb, a mid-sized Turkish bank, is officially in partnership negotiations with France-based bnp Paribas. Yapi Kredi Bank, which is to be sold by the end of October 2005, should also attract international interest, although whether Cukurova Group, the bank's former majority owner, repays a $2 billion debt to the bank will be critical for the bank's financial health.

The opening of EU membership negotiations will benefit Turkish banks even in the absence of a great merger and acquisition between a Turkish bank and a larger European buyer. First, it will loosen conditions for foreign lending to local banks, as the Turkish economy will look increasingly safe (as the EU talks will create the expectation that Turkey will continue to reform). Second, a consistent increase in Turkey's GDP per capita (currently just 30 percent of the EU-at-25 average) will mean a stronger domestic demand alongside more imports from Europe. Turkey's exports from the EU totaled $36.2 billion in 2003, a figure that is expected to increase with the launch of negotiations. A stronger domestic demand will yield more customers for high-margin retail banking products, particularly consumer loans and credit cards, as has been the case in the early stages of EU convergence for Poland, the Czech Republic and Hungary.

From a broader perspective, the advancement of the Turkish financial sector will benefit Turkey's progress towards eventual EU membership, as it will improve the investment environment and facilitate further European investments in Turkey. The EU negotiations are expected to anchor Turkey to EU standards, ensuring the development of a predictable free-market environment for foreign investors. The companies that have recently expressed interest in entering Turkey or expanding businesses have included British LNM Group in steel, France Telecom, Telecom Italia and British Vodafone in telecommunications, and British American Tobacco in the tobacco sectors. Optimists predict that foreign direct investment will triple its current low level of around $1 billion a year. In turn, increased interest from European companies will necessitate a robust financial sector to provide for investments.

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