Desperate times, desperate measures in Turkey

By bne IntelliNews January 25, 2011

Justin Vela and Nicholas Watson -

Desperate times call for desperate measures, the Turkish central bank is telling the markets. However, the unorthodox policies that the central bank is using to prevent the economy overheating and rein in the current account deficit have many worried.

Turkey's economy may be powering ahead, but the central bank surprised markets on January 20 by counter-intuitively cutting its benchmark interest rate to a record low of 6.25%, in an attempt to stem the huge inflows of short-term investments, or "hot money", that have been flooding into the country since last year. The bank began cutting interest rates in December, from 7.0% to 6.5%

At the same time, the central bank raised for second time in two months the amount of reserves that commercial banks must set aside against liabilities, which it said on January 24 would be 12% for immediate-access deposits and 10% for accounts with terms of up to one month. Both rates were previously 8%. This makes it more costly for the banks to lend and so the central bank hopes to put a lid on the boom in consumer loans and take the steam out of inflation caused by the cutting of interest rates.

The bank argues that this combination of lower rates and higher reserve requirements can take some of the air out of the ballooning current-account deficit, which is being inflated by these inflows of capital from abroad and imports that are being gobbled up by credit-hungry Turks. Turkey's current account deficit in 2010 is estimated at 6.3% of GDP, the highest ever. In 2011, this imbalance is expected to climb to a projected 7% of GDP, the "Achilles Heel" of Turkey's otherwise soaring economy, which is forecasted to grow 4.5% this year.

Some like Neil Shearing of Capital Economics cautiously welcomes the central bank's unorthodox move. "Turkey cutting its benchmark interest rate in the face of rapid growth... is actually part of a more sophisticated response to deter speculative inflows and prevent asset bubbles from inflating. A crucial component of this is macro-prudential measures, including higher reserve requirements. Once these measures are accounted for, policy has actually tightened. This is entirely sensible given that Turkey is one of the few countries in the region where core inflation could become a concern over the next 18 months."

Indeed, TurkStat, announced in January that inflation was 6.4% in 2010, the lowest rate over the last 41 years. On January 25, the central bank raised its forecast for inflation in 2011 to a mid-point of 5.9%, 50 basis points up from its previous forecast in the fourth-quarter inflation report, citing higher food price expectations and higher energy prices for the move. Earlier, the central bank governor, Durmus Yilmaz, had said he expects inflation to accelerate from the second quarter.

However, others are less convinced. Tim Ash of Royal Bank of Scotland says the central bank is clearly trying to nuance its monetary policy with lower rates aimed at reducing the carry allure for foreign hot money inflows and hence appreciation pressures on the Turkish lira, while at the same time moving to tighten domestic liquidity conditions to try and cap high rates of domestic credit growth. However, "this could be a difficult circle to square in practice - it remains a tough ask to communicate the policy to the market," he notes.

Likewise, analysts at Citigroup Capital Markets are sceptical about the effectiveness of the bank's unorthodox strategy in trying to restrain the deterioration in the current account balance, "as the large external financing needs continue to leave Turkey vulnerable to sudden shifts in investor sentiment."

Structural issues

A big problem for the central bank, say analysts, is at the root of current account deficit lies structural issues. With Turkey's economy long dependent on imports and driven mainly by domestic demand, each time in the past the country experienced a solid bout of economic growth, there was a corresponding widening of the current account deficit. This has been exacerbated by the recent global economic crisis; while Turkey's solid GDP growth led to an increased demand for foreign products, Eurozone demand for Turkish goods remained weak. "We used to import an iPhone and export an orange," one Turk who worked in the telecommunications sector says. "Now we still import the iPhone, but don't export the orange."

At the same time, low interest rates in the Eurozone and rounds of quantitative easing in the US - essentially, the US Federal Reserve has printed money and this wall of cash hotfooted itself into emerging markets - also pushed an unprecedented number of short-term portfolio investors into Turkey, a country that recovered quicker than most from the global crisis. "Put the money where the growth is," says Barbaros Ozuyilmaz, head of fixed income at Alternatifbank. "We are one of those countries. This foreign liquidity is coming to Turkey and other emerging markets. This liquidity creates a demand here, because you have cheaper credit due to the availability of foreign currency."

An additional worry for analysts about the new central bank policy comes from the country's politics. Capital Economic's Shearing says that while the central bank's policy of cutting interest rates to deter speculative capital inflows despite the economy's comparatively good growth prospects isn't the recipe for disaster that many predict, the key to its success lies with fiscal policy working in tandem with monetary policy - and with elections approaching this year, there are reasons to be cautious. "While the government is not (yet) planning a fiscal giveaway ahead of June's elections, a fiscal tightening is highly unlikely and the primary budget surplus will remain far below the levels seen last decade," says Shearing. "Accordingly, a growing current account deficit and the threat of overheating will remain at the top of the list of investor's concerns this year."

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