Turkish Central Bank Surprises Everyone with Interest Rate Decision

Central Banks around the world have been aggressively cutting rates in order to deal with the liquidity crisis. They are likely to engage in more cuts given some deflationary signs.

The Turkish Central Bank has also announced a cut in the borrowing rate by 50 basis points, citing slower than expected growth as well as decreasing inflationary pressures.

Everybody is shocked, including myself. What is not surprising is that some people seem to be angry because the TCB has finally decided to act like a normal Central Bank. Many seem to think that this is the wrong thing to do and could put further pressure on the currency that has already been acting weak. A London-based Goldman Sachs economist has opined the following regarding the action of the TCB:

It was a premature rate cut. There will be very strong depreciation pressure on the YTL and Turkish economic growth will fall sharply. It's the wrong time to start easing rates.

Am I reading this right or is this your run-of-the-mill fear mongering that is taking place after the injury? I guess we should thank the analyst for the heads up on this shrewdly ahead-of-the-curve currency devaluation warning. Readers of my earlier writings know that I presented my warnings before any warning signs were up as early as 2007. But I was more fearful that the Central Bank would raise interest rates in order to defend the currency, especially because it had done it a few times before and openly said it would do it again if necessary.

It does appear for now that the Central Bank has actually accepted this devaluation as a fact of life and is not defending the Turkish Lira or fighting to reverse the devaluation via raising interest rates further, at least for now. This is huge. Thus you can summarize MY current feelings more along the lines of shock and awe.

Let’s walk through the Central Bank’s shock-and-awe operation with some perspective to see whether the phony outrage against the rate cut has any basis in fact. Does a 50 basis-point rate cut indeed encourage more devaluation and hence less growth?

1. Given the fact that the rest of the world is aggressively lowering interest rates everywhere for more than 50 basis points, does a similar action undertaken by the TCB make any difference in terms of the interest rate differentials observed between its interest rates and the rates of other Central Banks around the world? The answer should be a clear no.
2. Given the fact that the borrowing rate was lowered to 16.25% from the former rate of 16.75%, does this “mighty” 50 basis-point cut have any power to make a meaningful difference in the general level of interest rates experienced in Turkey? The answer: No. But a 400 basis-point cut would definitely do the trick.
3. Does a 50 basis-point rate cut further exert a “very strong” depreciation pressure on the YTL that has already fallen from grossly overvalued levels due to liquidity flights out of the emerging markets scene as well as the stock markets all around the world? The answer: Same as above. Please refer to the idea of slashing rates by 400 basis points to see such effects.
   Not to mention that the Turkish currency has lost value and economic growth has already fallen due to global liquidity factors that the Central Bank has little control over, so let’s not pretend that if things get worse it will be because of the 50 basis-point rate cut.
4. What macroeconomic reason would the Central Bank provide for not lowering rates in an environment governed by significantly weaker growth, weaker domestic demand, lesser liquidity, and abating inflationary pressures? Note: Defending the currency via raising interest rates does not qualify as a textbook reason, and is a possible recipe for a worse disaster.

If you have followed my articles for the last 2 years, I’ve been an adamant critic of the Central Bank’s former decisions to keep interest rates high, which, given the ample liquidity in the world at the time, attracted more hot money than necessary into the Turkish markets and caused the Turkish Lira to reach exorbitant valuation levels. The high interest rates have been a boom for Turkish banks that lent at even higher levels to real businesses as well as consumers. Banks have registered record profits and strengthened their balance sheets by taking advantage of the liquidity while managing their risks carefully.

These are the same banks who are now unwilling to extend credit and who are calling debt earlier than due, despite having no toxic mortgage assets in their portfolios like their US counterparts.

However, the same level of interest rates have pushed firms in the real sector to pay even higher rates for their debt or forced them to borrow in other currencies. The resulting overvaluation of the currency has concurrently made it very difficult for Turkish production to stay competitive in the global marketplace.

Unless you have been following my former articles, you may be wondering how I seem to be so certain of the overvaluation thesis. The Central Bank of Turkey publishes data that shows a real effective index of the Turkish currency. That means inflationary differentials between Turkey and other countries get taken into consideration while all currency values are crunched into the equation in a trade weighted fashion.

If you have been following this data, the devaluation and the currently observed “weakness” of the Turkish Lira poses no surprise. In fact, many in Turkey have been waiting for it.

If the Central Bank had started easing rates earlier, we would not have observed such strengthening of the currency over 2007 and some of 2008, and hence the current drop in currency would not have been as severe as experienced now. Of course, it is conceivable that the Turkish Lira would now be at lower levels than it is right now given the capital flight that all emerging markets have experienced to date. But the graph above would look very different without the spike experienced in 2007 had the TCB not interfered aggressively by raising the interest rates for a total of 425 basis points during the sharp correction of May and June 2006. That intervention essentially stopped the freefall of the Turkish Lira at the time.

This is what I wrote in an article at Seeking Alpha to elaborate on the graph above while explaining the Central Bank’s interest rate policy and its influence on the Turkish Lira:

Note that both the 1994 and 2001 crises are associated with a sharp adjustment (fall) in the exchange rate. You may also see a brief drop corresponding to May and June of 2006, when world financial markets were roiled with a selling pressure upon comments made by the Federal Reserve regarding inflationary pressures. The Central Bank of Turkey aggressively defended the currency by raising interest rates by a total of 4.25 points, which practically stopped the developing trend of another free fall. While the intervention was seen as a successful defense of the Turkish markets against global financial pressures, it was indeed a false move that only retarded the correction of the overvalued currency by market forces.

Market forces now seem to take the form of a liquidity flight that naturally puts pressure on currencies of smaller countries to devalue. This article dates back to February 2007 and was written as a warning to Turkish authorities on what might come in order to be better prepared.

I have also maintained and defended the view that a more competitive exchange rate may be a major advantage as long as any possible currency devaluation is stress-tested to extreme levels and managed carefully. Thus risks stemming from such devaluations are better controlled. However, lack of liquidity and access to credit may wreak havoc when accompanied by a further devaluation of the currency.

The government is currently working on a domestic package as well as a stand-by agreement with IMF in order to deal with such possibilities. Soon we will have a better idea on the details.

Comments

[mdmrjsds:]

Thanks for your commentary.

Given interest rates of 16%+ I wonder how businesses can survive, let alone grow. Unless inflation is higher. The graph seems to indicate that it isn't as the real value of the currency is rising relative to the rest of the world.

So it seems to me that while the high interest rates will attract investment capital (if it is available, as you point out), they are also making it more difficult for the businesses in Turkey to compete in the international market (as you also point out). As an aside, with the additional step of pegging the lira to the euro they could make Turkey mercantilist like China, accelerating economic growth at the price of lower domestic consumption. Is it your opinion that this policy of high interest rates is to raise currency value as an indication of status rather than looking to expansion of the economy, and thus wealth of the population? You seem to imply this, while not explicitly stating it.

PS I think this whole concept of central bank as economic control is flawed, not only in Turkey but everywhere in the world, but I'm questioning like a Keynesian here.

2008 Nov 25 12:12 PM

[Steven Hansen:]

suna,
you are the second person i have read that links the high interest rates to attracting capital for business. i do not get it. the reason for the high rates is that the government of turkiye needs to finance its debt. turkiye is one of the first countries to go to the imf for money. the government has been spending beyond its means.

business in turkiye is hitting the proverbial wall. it really needs low interest rates to stimulate its economy. because the government debt is so high it cannot lower it to help business. the short term outlook for turkish business is not good.

2008 Nov 26 01:30 AM

[Fed Up AsUsual:]

Conventional text book analysis grounded in variations of Keynesian or Monetarist dogma is woefully inadequate for anticipatoing major currency movements particularly in Turkey. Alternative analysis grounded in a simple Miseian marginal utility analysis has been much more effective in anticipating and profiting from every major movement in the Turkish Lira for the last 20 years. Perhaps this is because while Turkey has the embodyment of Bretton Woods type institutions they have only become operationally effective in a the manner conceived very very recently, while all along the underlying and pervasive traditional systems of a bygone era have continued to be far more influential within the Turkish economy generally, as the IMF finally seems to have learned in the early part of this decade.

The simplistic view that high interest rates attract capital inflow is long outdated because it presumes a static environment for typical mathematical convenience, and ignores the real time real world reflexivity of pricing. The expectation of interest rate declines actually attracts capital inflow from money managers in anticipation of asset value appreciation, and from FDI in anticpation of growth, thus pressuring currency prices higher, not lower..

Hence the rally in the Turkish Lira on the back of the CBs interest rate cuts. Never mind the IMF stand by agreement- Simsek is right in certain respects- it is too soon for Turkey - there is precious little similiarity betwen the Turkish economy and any "former Soviet block heretofor control state economy" or other basket cases- no commentator can begin to arrive at a money making forecast of the Turkish economy without first recognising what aspects of the Turkish economy are institionally and systemically unique. Utilising analysis from the group think of western business academica is merely a distraction and burden - clean your glasses with a study of the economic and financial history of Istanbul - for all but perhaps the last 200 of 2000 years, the preminent imperial nexus of western commercialism..
.
Also outdated is the view that Turkey needs to sustain capital goods imports to sustain growth. Clearly the attractiveness of the Turkeys fast growing consumer goods markets are a magnet for portfolio investment and FDI - factor that into your Keynesian Bretton Woods oriented capital account analysis.

Also generally outdated is the view that returns on capital and capital inflows are the most important determinant of a currencies exchange rate, as the impact of unwinding yen carry trade illustrates, the cost of capital and capital outflows need to be taken into account, and are often more significant. (although in Turkeys specific circumstances this factor may not be presently illustrative of the point.)

Perhaps the most important factor of a countries currency price and exchange rate is the future expectation of that rate- and where fx rates are driven to extremes, in the majority of cases over the last 20 myears it is interest rates that re-act to the currency movements, and not exchange rates reacting to interest rates - everywhere.

So how long will we bored senseless by the use of an oversimplistic interest rate - exchange rate analysis by policy makers, academics, and market economists in investment banks that should know better? Does each generation have to re-learn their analysis through an education by the markets, or will one day the mechanisms of market economics finally reach the hallowed hallways and classrooms of our academic instituions...

2008 Nov 26 04:15 AM

[Suna Reyent:]

Thank you for the comments. There are quite a few points above that need to be taken very seriously - possibly requiring full blown articles (or more) in order for me to address them in a fair fashion. I will do so in a following write-up.

2008 Nov 28 04:54 AM