Analysts bashed Turkey’s central bank following a surprise cut on August 4 that brought the policy rate to 5.75% from 6.25%. The move formed part of a broader policy mix that, on balance, resulted in monetary easing.
The main bone of contention is that many analysts believe Turkey’s economy is overheating, making a rate cut seem reckless. However, a variety of data suggest overheating concerns are misplaced and point to a sharp global downturn as the bigger worry, as I will detail below.
While the central bank (CBRT) could certainly improve its signaling of policies, I am willing to give the CBT the benefit of the doubt for now. The real test will be whether the CBT proves as proactive at raising the policy rate when conditions require it.
Criticism of the CBT
The quote below from Tim Ash of RBS, as published by the FT, is representative of many in the overheating camp:
“The danger with this totally out of the box move is that investors will seriously begin to question the credibility of the CBRT as an institution, given that foreign investors prime concern at present on Turkey are fears of overheating as reflected in the CAD.”
Also, see this comment from Danske Bank:
“Turkish GDP growth is still in double-digit territory and the current account has clearly grown to an unsustainable level. Any normal inflation targeting central bank with this kind of data would tighten and not loosen monetary policy.”
Rejoinder to Overheating Claims
The domestic economy is showing signs of moderating, rather than overheating. Yes, GDP has grown strongly, but this has to be seen as part of a natural bounceback in the wake of a sharp downturn. This rapid pace of growth is not expected to continue.
Below I highlight some data that suggest Turkey’s economy is not overheating.
Figure 1: The capacity utilisation rate sits below pre-crisis levels and dipped in July
Source: CBT
Figure 2: The annual rate of growth of industrial production has fallen steadily for the past five months
Source: CBT
Figure 3: The real sector confidence index – an indicator of business conditions and an important leading indicator of growth – dipped in July to its lowest level since 2009
Source: CBT
Figure 4: Inflation is above the year-end target of 5.5%, but not far above, and it’s quite low in a historical context
Source: CBT
Sidenote: Many in the overheating camp point to a high current account deficit, approaching 10% of GDP in 2011, to support their claims. The current account deficit is certainly high and this is quite worrisome. However, the deficit is largely structural (owing to Turkey’s heavy dependence on energy imports as well as a chronically low savings rate). This means that it’s not a short-term problem and neither the central bank nor government can simply wave a magic wand and fix it. I will tackle this issue in a later blog post.
Worrying Signs in Advanced Economies
While the domestic economy is showing signs of moderating, the data above do not by any stretch of the imagination justify a rate cut. So it’s necessary to look at the worsening outlook in the US and eurozone, which I detail below, to understand why the CBT opted to slice the policy rate. As the global financial crisis showed, Turkey’s economy is quite vulnerable to developments in the advanced world.
US
- The Fed Open Market Committee recently highlighted the downbeat state of the US economy in its August statement and said economic growth in 2011 is slower-than expected.
- In July, the US government released its latest set of growth figures – including revisions going all the way back to 2003 that show the recession was worse than expected. The contraction in real terms, from peak to trough, was 5.1% – one percentage point worse than thought. See related article from BBC.
- In his August 26 speech at the Jackson Hole conference, Bernanke noted that output in the US has still not returned to pre-crisis levels and that unemployment continues to hover at rates of over 9%. He also said that the Fed has revised down its US growth outlook. At the same time, he made no commitment to any new quantitative easing measures.
Eurozone
- There is no resolution to the eurozone crisis on the horizon given ongoing political wrangling, and problems seem to be intensifying with Italy moving into the spotlight. The ECB’s bond buying is only a stopgap measure, as Marc Chandler notes in his recent post: Why I Am Going to Worry About Italy on My Summer Vacation.
Other Factors
In an April presentation, the CBT notes its desire to keep interest rate differentials as low as possible in order to prevent large inflows of speculative capital into Turkey. The concern is that such flows can rapidly reverse in the event of an external shock or shift in investor sentiment. The CBT’s decision to cut the policy rate supports this objective as it narrows the interest rate differential vis-à-vis advanced economies.
Note of Caution: Political Pressure May be a Factor
Yavuz Canevi, who helmed the CBT in the mid-1980s, gives voice to worrisome rumblings that pressure from the government may have helped motivate the surprise rate cut.
According to Bloomberg, Canevi said: “I really would not say that the central bank had pressure, but psychologically you can call it pressure. The current governor is much closer to Deputy Prime Minister Ali Babacan than the previous governor. They were childhood friends” and Basci is trying “to accommodate the policies of the current government.”
I believe the real test will be whether the central bank proves as proactive at raising rates when conditions change and this is something to carefully track.
Bottom Line
A range of indicators show domestic economic activity is moderating. Turkey has a wide current account deficit, but that’s largely a structural problem (a very big problem!) and there are no quick fixes. Meanwhile, the global economy looks headed for increasingly choppy waters.
In light of these events, the central bank’s decision to cut the policy rate does not look so absurd and could even be hailed as ahead of the curve. While part of the CBT’s motivation to cut rates may be due to indirect political pressure, I am willing to give it the benefit of the doubt for now.
While I don’t buy the overheating argument – I think most analysts don’t buy into any longer – I don’t see any reason to give the central bank the benefit of the doubt. The economy is cooling, but not thanks to its central bank’s policy wisdom. Growth is slowing because growth is slowing everywhere, and I’d argue that the bank’s policy earlier this year even exacerbated the current account problem. While part of it is structural, imports of consumption goods are not structural – that’s the result of interest rates at record-low levels even as unemployment is below the pre-crisis average.
Your point on inflation being low by historical standards is true – but the bank’s inflation target is low by its own historical standards – it was 6.5% last year, and higher in earlier years.
While I can see the central bank being vindicated in some sense as the global economy is heading for choppy waters, the timing didn’t make sense. The lira was under a lot of pressure in the days leading up to the interim meeting and not many people expected a rate cut (expectations matter whether we agree with them or not). The lira has depreciated significantly and for a country with deficit in the current account so large, the weaker currency reduces the return on investing in Turkey by a foreigner – the central bank is now selling FX reserves, which are just barely more than 100% of ST external debt. Also, why not just wait until the regular August monetary policy meeting which was scheduled only 3 weeks later?
Overall, I enjoyed your post and find your views more insightful than many other bloggers/ economists.
One question that I have not seen an answer to anywhere – how is it that the central bank of Turkey can get away with cutting rates (not 125 bps) since December 2010 while most other EMs that are growing robustly (from the crisis) have tightened? Even if you assume a rate cut was justified in August, Turkey was growing at a similar pace to other large EMs, yet Turkey got away with cutting interest rates over 1,000 bps during the crisis and another 125 bps after. Did something change structurally to justify rates being so much lower?
Thanks for the great comment! You bring up a number of important points.
1) I agree with you that the slowing economy should not be ascribed to the central bank’s wisdom. As I tried to argue in the post, Turkey’s economy grew quickly after the crisis and part of this is due to a natural rebound effect (or positive base effects, as some would say) and these effects are now petering out. Also, as we both point out, growth is slowing down globally, which in turn will drag on Turkish growth. The central bank’s macroprudential measures (eg. raising reserve requirements) probably helped engineer the slowdown, at least at the margins, but it’s hard to say as we don’t have a counterfactual and can’t predict clearly what would have happened without them.
2) You note that the central bank’s record low policy rate may have exacerbated the current account deficit by increasing (or at least, not staunching) demand for imports of consumption goods. This is true, but I don’t believe it had a significant effect on the widening of the CA deficit.
The real problem in Turkey are the structural drivers of the CA deficit, which the CBT can’t do much about, at least in the short run. I will address this point more in a later post. For now, I’d point to the imports data by BEC category (http://www.turkstat.gov.tr/PreIstatistikTablo.do?istab_id=629). Imports of consumption goods (including food and gasoline) account for a very small share of total imports (only 13% so far in 2011, a similar percentage to previous years). Intermediate goods imports make up the bulk of Turkish imports (over 70%!, which is incredibly high). These imports are used in the processing of Turkish exports and are intimately linked to trends in Turkish exports. If exports rise sharply, then so do imports. As a result of this structural issue, it is challenging for Turkey to address the persistent trade deficit.
3) “While I can see the central bank being vindicated in some sense as the global economy is heading for choppy waters, the timing didn’t make sense….why not just wait until the regular August monetary policy meeting which was scheduled only 3 weeks later?” Yes, this is a very legitimate question and deals with the central bank’s communication and signaling, which could definitely improve. On a separate blog, one commenter noted that Turkey’s rate cut came one day before the S&P downgrade of the US, which is certainly interesting timing.
4) You mention that the significant lira depreciation makes it less attractive for foreigners to invest in Turkey. Yes, this is true, especially for carry traders who are concerned about fx volatility that can wipe away their gains, but Turkey still offers relatively high yields. Brazil offers higher yields, but the country also has implemented capital controls, making it more costly for foreigners to pull out their money in times of stress. Meanwhile, we’re living in age of currency wars where most countries would like to see the value of their currencies drop vis-a-vis their trade partners in order to give their exporters a competitiveness boost. Theoretically, the lira depreciation should help Turkey’s CA deficit by making imports more expensive, in local currency terms, and by making exports more competitive.
5) As you note, fx reserves in Turkey barely cover the short-term debt. I think this hits the nail on the biggest problem facing Turkey, which isn’t just the wide current account deficit, but rather how it’s being financed. Turkey looks incredibly vulnerable to a sudden stop in capital flows. I agree that selling fx reserves probably isn’t the best idea. The CBT may be attempting to shore up investor confidence by preventing too much fx volatility, but I don’t fully understand the rationale. If you’ve made it this far, are there any other commenters that want to jump in on this issue?
I am long Turkey but the current growth rate is definitely causing concern. It is either that or the fact that I am on Chapter 10 of “This Time is Different” discussing how huge capital inflows precede major financial crisis. Turkey, just like their red hot comparitor China, seems to be on the same course.
Good article.
Economist Emre Deliveli, who blogs at Economonitor.com, politely corrects me. “As a follow-up point, EMM [that's me] interprets the rate cut as the Bank trying to prevent excessive capital flows. Ceterus paribus, that would have been the case, but they also narrowed the corridor for overnight rates, noting that the decision was to attract short-term flows by decreasing the volatility in the overnight- the rate cut, on the other hand, was justified as a response to the global slowdown.” Here’s his post: http://www.economonitor.com/emredeliveli/2011/08/28/odds-and-ends-on-turkey/
Before making the blanket statement that the CBT was trying to prevent hot money flows (which was the CBT’s previous intent), I should have paid more attention to the CBT’s narrowing of the interest rate corridor . And I completely agree with Emre that the CBT could improve its policy communication.
I don’t think we should be concerned about Turkey, at least not yet. Other than that, a good article.