Turkey's Audacious Experiment in 'Post Modern' Monetary Policy

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The recent decision of the Turkish Central Bank to lower rather than to raise interest rates in a risky attempt to quench the inflation flames that many feel are threatening to engulf what some call an "overheating" economy (or here) has lead to a good deal of heart-searching and consternation in the economic and financial press of late. After all, at the end of the day aren't they doing exactly the opposite of what the textbook says they should? Well, as is usual in the realm of the dismal science, all is not exactly what it seems to be.

To put the issue in some sort of context, the background to this decision is undoubtedly Ben Bernanke's move in early November to extend US monetary easing, by going one bridge further in his assault on the housing deflation and continuing high unemployment which weigh down the economy by introducing what effectively amounts to a second round of exceptional policy measures (known colloquially as QE2). The leading objective behind this move was to increase the amount of liquidity available in the US economic and financial system, although a more covert consideration was clearly to weaken the dollar in an attempt to boost exports and use the strength of external demand to tow the US consumer back towards growth territory. Joining up the dots, we find that the key link between these two otherwise seemingly unrelated central bank decisions (after all one is concerned with an economy which is growing too slowly, while the other is working with one which may be growing too quickly) is to be found in the fact that the US economy is already saturated with as much liquidity as it can handle (in terms of the capacity for absorption of the domestic sector) and as a result the funding made available works its way through to more attractive, and more profitable outlets across the developing world.

So what has happened in practice is that large quantities of liquidity have been been seeping out of the back door, some of it undoubtedly heading over to Europe in the search for the reasonably safe but still quite attractive pickings which have become available due to the Sovereign Debt Crisis, but the lions share is surely making its way towards those, seemingly "risky" rapidly growing emerging economies.

This has lead to a certain amount of angst and confusion among developed economy political leaders, with Angela Merkel, among other European politicians, voicing the complaint that the financial markets are effectively "mispricing" risk. Personally, I don't claim to have any special insight into whether or not the markets are pricing risk well, or badly. I would have thought that that was exactly why we had markets in the first place (rather than a centrally planned pricing mechanism): to put a price on risk. But that being said, the systematic downgrading of the aging developed world and the systematic upgrading of the youthful "growth" economies in the third world has a certain logic to it.

Obviously, in a world which is as rapidly changing as ours is, markets need time to adjust. And market participants are evidently a vulnerable as anyone else is to the human failing of getting things wrong. Markets are not superhuman entities, their outcomes are the aggregated product of a very large number of individual human decisions. But I think it is important here that all concerned recognize their own limits and limitations. It is either an extremely bold or an extremely foolish politician who feels equipped to move to a higher level to pass judgment on a process whose outcome is still remains an open question. Post hoc, as we have seen in the wake of the recent financial crisis, there is no shortage of critical voices, and all and sundry have a notable facility to point the accusing finger to tell the markets "you got it wrong"! But telling them you have it wrong before the event, well that takes gall! And if you are really so sure, then put your money where your mouth is, and buy up all that debt the markets evidently don't want.

In fact, markets are neither omniscient, nor omnipotent, and often move as much behind the curve as they do in front of it, correcting to changing underlying realities in a herd-like fashion and even then only after a time lag. Yet, as I say, there is a certain logic behind the most recent trend, which involves repricing risk in the developed economies (due to their aging populations, and large uncovered obligations with the future, issues whose importance was not sufficiently appreciated and accounted for in the pre-crisis world ), at one and the same time that risk in the developing world is also repriced, since emerging market "risk" may not be quite so risky as the "old normal" mindset used to think it was.

As a result, a number of key emerging economies find themselves in the pleasant position of enjoying the benefits of a win-win dynamic, since far from struggling with ever higher elderly dependency ratios, the proportion of their population in the labour force (and also in employment) is now rising constantly, while both inflation and interest rates (including ones related to country risk) are trending downwards in the longer run. Turkey is, in fact, one of these fortunate economies, which is why I think the latest move from the Turkish central bank needs serious consideration, and should be understood not as just one more piece of "midwinter madness", but rather seen as part of a much more calculated and comprehensive strategy which comes from a modern and continually evolving tool set. New problems need new remedies, so let's leave small open (and even large open) economies where they belong: in the unreal world of the academic textbook. In today's world interest rates are not set locally, and excessive domestic inflation is often produced more by the dynamics of global capital flows than by the irresponsible spending decisions of local politicians. Which is not to say that the Turkish central bank have the balance right (or wrong), but simply to state that global problems require global solutions, and in the meantime, national leaders will have to adapt their policy mix to confront new problems, problems which but a few short years ago would have seemed almost unimaginable.

Complex Problem Set With A Positive Outlook

As Erdem Basci, deputy governor of the Turkish central bank recently argued, strong capital inflows (see chart below), fueled by quantitative easing in developed economies, are in danger of producing the undesirable outcome of distorting economic development in emerging economies and potentially fueling asset bubbles in the longer run. According to Basci, as argued in a posting on the central bank website, the best policy response to this thoroughly modern problem is to try to make these countries less attractive to short-term investors by cutting interest rates in a step-by-step process (a move which would also make the country more attractive to longer term investors - think FDI), while making extensive use other tools to attack the excess liquidity problem and restrain domestic credit growth. (Click to enlarge charts)

And so it was to be, since the central bank's monetary policy committee voted at its most recent meeting to cut the reference lending rate by 0.5% (to 6.5%). This move was rapidly followed by the second of the steps advocated by Basci, since the bank then announced that the required reserve ratios (RRRs) for Turkish banks would be lifted to 8%, a move was expected to drain an estimated 7.6 billion Turkish lira (or $4.9 billion) from the economy in one foul swoop, with the objective of reducing the amount available for Turkish banks to lend to their clients.

Now in order to make sense of this decision, the key point to grasp is that Turkey's economy is not, in fact, currently overheating. At the present time, the very opposite is happening, since the economy has been slowing, with the quarter-on-quarter growth rate falling in the third quarter to a "mere" 1.1%, down from the sweltering "China like" pace of 3.7% clocked up between April and June. Now a 1.1% quarterly GDP growth rate (or a 4.4% one annualised) is not exactly small beer by present developed economy standards, but it certainly is not overheating territory for an economy in the process of making the shift from underdeveloped to developed status in the way that Turkey's is.

Nor is inflation showing signs of getting out of hand. True, at around 7% it is still stubbornly high, but it has been stabilised, and shows no sign of getting out of hand, while the core inflation rate has been falling steadily, and is now around 3%. So while the situation signals caution, it hardly cries out for drastic monetary tightening.

So, what the recent decision was really about was not an attempt to conform with the objectives of conventional monetary policy. Rather, the move was intended to dissuade and deter speculative investments looking for higher yields from continuing to pour into Turkey and magnifying the economy’s key weakness: the mushrooming current-account deficit. The idea was to reduce the yield differential with lending rates in the quagmired developed economies.

So the problem facing Turkey's policy makers is not the economy isn't growing, or that it is growing too quickly (there is plenty of spare capacity left out there), rather the problem is that it is growing in an unbalanced way. The high yield differential, and the funds inflow which it is producing, means that the currency is appreciating even while inflation remains excessively high (now stuff that in your textbook and smoke it), and this combination is a sure fire way for the export sector to lose competitiveness. And this is in fact what is happening, as imports (driven by the consumer credit boom) surge, while exports fail to keep pace, with the result that the trade balance deteriorates, and along with it the current account one.

But as Erdem Basci, among others, including some IMF economists, argue, hiking interest rates could be totally counterproductive in the current climate since it might well serve to make the country even more attractive (by increasing that key yield differential) to precisely the kind of funds they want to deter. Turkey, as many analysts constantly point out, has become overdependent on the wrong kind of funding to finance its current account deficit. What Turkey needs is to attract longer term investment finance, and while reducing the volume of short term speculative finance which is currently distorting prices in the country's equity markets. This argues for lower, not higher, interest rates, since bringing the longer run cost of borrowing down should make the country more attractive to the kind of investor it needs.

So the bank have decided to adopt a monetary experiment based on a resort to other measures, and the first of these is an attempt to withdraw some liquidity from the banking system. One of the principal worries is that the rapid expansion in the volume of domestic credit has triggered a rise in imports and thus aggravated the deterioration in the current account deficit. But the problem is not only a current account deficit one. The following chart (prepared by staff at the Turkish economic research institute TEPAV) shows that the credit expansion is also associated with a rise in the systematic risks of the banking sector, since much of the lending is evidently being financed by short term fund flows.

Net foreign financing of Turkey's banking sector hit US$17 billion in the last quarter of 2008. Subsequently the level fell rapidly, but with the economic recovery foreign funding has once more been on the increase, an as of October 2010 it was in the region of US$22.5 billion. One important characteristic of the foreign funding the Turkish banks have been accessing since the advent of the recovery is that something like 98 percent of the funds are short term. This sharp rise in short term funding is not only unprecedented, it is also highly dangerous, since were there to be a sudden change in risk sentiment (due to factors which had nothing directly to do with Turkey itself), such funding might not be renewed, leading to a maturity mismatch between the banks' borrowing and lending which could severely strain the Turkish financial system.

The central bank is therefore pretty concerned to slow the rate of credit expansion, and with this in mind it has also introduced a second bloc of measures involving steps to contain the rate of expansion in consumer credit - credit card restrictions, increased loan to value ratios in house purchase, etc. Due to the endless ability of those who are smart enough to find ways to get round such rules, none of these are perfect, but they are a lot better than nothing, and nothing, some will remember, was those responsible for managing the Spanish and Irish economies did when their credit and indebtedness ratios were obviously on the verge of getting out of control, and when the relevant central bank seemed to see no inconvenience at all in applying negative interest rates to their already credit-bloated economies. So by all means criticise the Turkish central bank, but let's be clear what (and who) we are comparing them with.

Obviously additional measures could and should now come from the Turkish government. Measures which involve the judicious (and even aggressive) use of fiscal policy to drain in the most direct fashion excess demand from the system. In this context it is pleasing to be able to note (see below) that this year's strong rise in tax revenues is not being matched by an equivalent increase in spending. Indeed the country is now running a quite strong primary budget surplus. More of the same, and then some, is what we need to see, but with elections looming it is doubtful decisive steps will be taken until the new government is formed.

And it isn't only rapidly growing credit that is a concern, a lot of the money has gone into Turkish stocks which are now not far off their 2008 pre-crisis highs. In fact foreign purchases of Turkish financial assets rose to around $15.5 billion in the first 10 months, from $730 million a year earlier, according to central bank data. In October alone, international investors bought $969 million in shares and $1.5 billion in government bonds.

Summing up, it is hard to say at this point whether the Turkish central banks attempt to operate what some have called a "post modern" monetary policy will work exactly as intended, especially since the outcome is not directly in the hands of the central bank, and very much depends on the determination of the government to take the necessary measures on the fiscal side. But whatever the outcome, of one thing we can be sure: doing something always has to better than doing nothing. After all, who else would knowingly and willingly wish to end up in the kind of unfortunate situation Spain and Ireland now find themselves in?