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Turkey’s Novel Fiscal Concoction

|Includes: TKF, iShares MSCI Turkey ETF (TUR)

Turkey has been doing exceptionally well among the emerging market countries, with a recorded growth of 8.9% during the first nine months of 2010. But with the new moves pulled by the central bank, the country seems to have become the subject of an entirely novel monetary policy.

Back in October 2008, Turkey was the only country paying such high overnight interest rates at 16,75%. Cheap money pumped into the system by the quantitative easing program of the Fed in order to put a stop to rising unemployment and revive consumer spending in the US has spurred a new bout of carry trade in the emerging market economies, inflating the lira in Turkey and causing the country’s current account deficit to widen to an estimated 6,6% of the national GDP.


Retaliation from the central bank came in May 2010, when the bank opted to one week repo rates as key interest rates for enacting government policy, selling securities from a fixed 7% instead of open bidding. Unlike the market a decade ago, the current economy is apparently in need of liquidity, according to Yilmaz Durmus, governor of the Central Bank of Turkey (NYSE:CBT).


Last month, the CBTannounced new interest rates to be implemented as part of the monetary policy, lowering the benchmark rate to a new record low of 6.25%, in order to dissuade the liquidity deriving from the quantitative easing undertook by the developed economies, i.e. the so-called speculative hot money, from pouring into the country’s economy and creating at the least, a credit bubble. The rates remained unchanged after the Bank’s latest meeting three days ago.


The surplus of the high amount of funds injected into the system through repo sales are  recollected by the central bank at the end of the day, but from a significantly low overnight borrowing rate. The bank had slashed the interest rates abruptly from 5,75% to 1,75% in November, and later onto %1,5 in December.  


“The message we are determined to give to the commercial banks is simple: Don’t bring the money back to us. Lend it out, loan it to creditors, but if you want to deposit with us at the end of the day, the interest you will be receiving on it would be only 1,5%” declared Yilmaz, trying to explain the fundamentals behind their actions. The bank has also stopped paying interest over the required reserves held at the central bank effective from September 2010.


This sudden cut in the interest rates has of course set the markets on alarm, fueling the dollar to touch 1,62 lira and the Euro to 2,17.


Eight weeks now since the central bank implemented this new and unorthodox policy, and it seems at a first glance as if some the goals have been achieved. Around 8 billion dollars worth of short term investment is claimed to have left the financial markets of Turkey. Investors, while liquidating their positions have caused the lira to weaken around 5% against the dollar, setting the exchange rate at around 1,60.


The inflationary consequences of the rate cuts were sought to be counterbalanced by increasing the required reserve ratios, thus raising the cost of borrowing of the commercial banks and limiting the amount of credit being lent out to the consumers. A depreciating lira is also welcome by the central bank, which makes exports cheaper and imports more expensive, helping to reduce the current account deficit.


However, a weaker lira also means higher inflation, especially at a time of rising food and commodity prices. Turkey’s inflation has fallen to nearly a five-decade low level. However, this encouraging outcome may likely be overshadowed by increasing cost and supply-side pressures partly because the weaker lira increases the price of imported gas and oil.


But the current picture is not all sunshine and roses. Turkey’s trade deficit soared to 71,5 billion dollars, rising by more than 84% in 2010 and even surpassing the 69,9 billion record which was set in 2009. The country’s perennial problem is the mushrooming current account deficit, fueled by cheap consumer credit. Imports are rising while exports are having a difficult time trying to keep up  with them and the result is a trade imbalance, which in turn deteriorates the current account as well.


According to the latest news, Turkey’s 2010 current account deficit soared to an immense 48,5 billion dollars, although the medium term program had foreseen it standing around 39,3 billion. The increase is 247,1% from the previous year.


Turkey is currently in dire need of deterring short term foreign financing because it’s economic growth has dangerously become over dependent on it.  The central bank and policy makers are determined to tackle this everlasting problem which has been no doubt causing them sleepless nights, even if it means steering the ship towards uncharted murky waters. Fear is that the widening imbalance as pointed out earlier may leave the economy vulnerable to shocks if the tide turns negative.


Unfortunately, the remedy implemented by the CBT has not been all well understood by the markets. Recently, bond rates have climbed to a seven month high of 8,35%, resulting from the liquidation of government bonds by the commercial banks in order to raise cash for their operations, who are now in turn cornered by the higher reserve ratios.


The CBT has left the rates unchanged after this week’s monetary policy meeting, not disappointing market expectations. However, Governor Durmus Yilmaz has again made it clear in an interview that the “mix of low rates and high reserve-requirement ratios may be implemented for a long period” should capital inflows continue at a faster pace.


With foreign investments seeking exit and the index falling below the 200 day moving average, the iShares MSCI ETF (TUR) has entered a downward movement after the rate cuts of the central bank. The country’s new monetary policy is likely to have  a negative impact on the stock market and it seems as if the index which was already showing signs of being over brought is subject to more than a mere correction in the near future.




Disclosure: I am short TUR.