Is growth sustainable?
low quality for a number IT ISN’T, AND IT IS ALSO of reasons. It isn’t first because earnings are low. Earnings are low because productivity is low. Net profits are also low because firms are heavily indebted, in both FX and TRY terms, and EBITDAs don’t translate into the bottom line to shore up equity capital. Add to these the impact of the pandemic. Many sectors are practically closed. Second, growth isn’t sustainable because equity capital is weak, FX and TRY credit debt takes its toll, and the vicious cycle continues. The other side of the coin is because capital is scarce given high growth and prosperity ambitions – with a retrograde and deteriorating education and university system, things are getting worse day by day - it all depends on foreign capital inflows, mostly portfolio inflows. If the financial account deteriorates, growth falls; they go hand in hand. Adding insult to injury, if the policy mix is wrong and if the financial account is going sideways, reserves are depleted, except of course episodes of somehow booming net errors & omissions. There is also concern about the rule of law and doing business. Hence, FDI is nothing compared to the financial account.
A TYPICAL MIDDLE INCOME TRAP
This is a typical middle-income trap. Unless Prometheus is unbound by chance, it warrants a conscious government-driven, all-encompassing initiative. The private sector alone can’t do it; it has proven this incapacity many times. The private sector is not only myopic, but it is dependent on subsidies, tax amnesties, credit guarantee funds, selected incentives – mostly conditional upon political affiliations - and suchlike. Even worse, the private sector itself is struggling to survive these days, and can’t orchestrate a technologically-driven investment wave well-ordered within a comprehensive macro framework.
Portfolio inflows don’t help much either. The trend-wise decoupling from EMs over the last 8 years is now clearly visible. There is never a sudden stop, reminiscent of the 1990s, but the ‘slow death’ endures. Because old generation EM crises are now out of joint with financial realities, the new trend is a slow decay. Everything takes time now. There may be a reversal in 2021, because the CBRT is on track, but to what extent can a partial comeback of portfolio investments remedy all these vulnerabilities? Could exchange rate stability alone do the trick?
DO TRADE BALANCES MATTER?
The intertemporal approach goes beyond the Mundell-Fleming model, and as Maurice •bstfeld has put it, it gives us a tool for thinking about the interplay of external balance, external sustainability, and the equilibrium real exchange rate.
Any approach that fails to take into account capital gains and losses on the net foreign asset position, i.e. valuation effects, would necessarily be misleading in a world of instantaneous financial capital flows. The currently huge gross cross-holdings of foreign assets and liabilities make sure that asset price movements largely affect highly leveraged country portfolios.
Balance of payments reports the current account at historical cost, and the same consideration applies to the national income accounts. Nevertheless, for countries that either issue huge chunks of debt in foreign currencies, or for countries that hold large amounts of assets in foreign currencies – China and Japan are now good cases in point - it is imperative to take into account valuation effects. Turkey more or less falls in this category, and not because of its large foreign asset holdings but because of its large FX-denominated debt. Furthermore, the standard intertemporal approach not only overlooks the financial adjustment channel and focuses solely on the traditional trade adjustment channel, it also by the same token downplays the role of risky investments and that of adjustment costs. Therefore, the terms of trade only show that net exports may or may not contribute to growth in the long-run. The balance of payments per se only provides an account of how international competitiveness unfolds.
The current account only showcases the amount of FX-needs on a monthly basis. The financial account, including valuation effects, determines the final verdict.
THE EXCHANGE RATE CONUNDRUM
By how much can a central bank be ‘behind the curve’? If interest rate moves are biased, i.e. tilted towards one end only (rate cuts), it can drag its feet for a long time. If we look at the exchange rate basket, we can observe that from October 2010 to October 2020, a whole decade, the CAGR is 17.56%. This is a huge annual combined depreciation rate. True, the lira is now appreciating, and is shedding the overshoot bubble, but still the decade-long depreciation is huge. It isn’t only because monetary policy was often on the wrong foot, of course; and besides, interest rates can’t perform miracles. However, the most powerful tool any central bank has in its arsenal is the policy rate.
Consider the O ctober 2002 - October 2020 period. Over 18 years the basket posted a CAGR of 9.7 only. This means in the first 8 years, the lira didn’t actually lose much value. Between October 2002 and October 2008 the lira depreciated by only 1.55% per annum nominally. That is, it appreciated after inflation differences with trade partners accounted for. The story changed in the 2010s. Inasmuch as we look at recent data we see a larger and continual depreciation. The slope says it all. Moreover, the pass-through has also accelerated. The graphic depicting the interest and the USD/ TRY rate has clearly traced scissors in the last two years. That kind of shape has not been observed over a decade until 2018. The turnaround was necessary, but it isn’t a panacea.
INTEREST RATES
Where should the lira rate stand? Or is measuring a natural rate of interest a good idea? While it wasn’t as widespread as the popular NAIRU, it had its uses. However, there are few studies aiming at computing the TRY natural interest rate. It is possibly because it is time-varying and isn’t easy to model unless we resort to phenomenal approaches (filtering or using SVARs, etc.). Because it is time-varying, it may not be readily available for a policy-oriented approach.
As such, the ex ante real interest rate stands at c. 3.8%. Can the natural rate be significantly above it so it can provide an argument for a permanent rate hike? John Taylor suggested, after the Global Financial Crisis of 2007-2009 that the Fed had kept the rate of interest much lower than his Taylor rule had suggested, running therefore unnecessarily loose monetary policy that caused the crisis. Not so simple for economies subject to more frequent structural breaks and wide open to measurement errors. First, the new potential GDP growth rate has to be at least one percentage point higher than what the old series imply. If it is c. 4.5% then the current real rate of 3.8% is probably close to, but somewhat lower than, the natural rate, given CPI that tends to become sticky at around 9.5%. Even so, the prime argument can’t refer to the not so easily measurable a natural rate of interest, but to financial stability. Because inflation can’t be subdued by simply raising the rate of the funding cost more; it has other reasons than overheating. Putting the same argument somewhat obliquely, an exchange rate that depreciates more than anticipated would cause an inflationary surprise, lowering therefore the ex post real rate of interest. In that case, a rate hike would prove to be a precautionary move. •therwise, c. 4% is a good ex ante real rate provided that it offers the same ex post real interest. It can suffice to ensure exchange rate stability.
BEHIND THE CURVE OR AHEAD OF IT
In general, people resort to simple Taylor Rule computations in order to assess which central bank is most ‘behind the curve’. They can be tricky though by being deceptively simple. Suppose the potential GDP growth rate is 4.5%. Suppose the effective inflation target is (still?) 5%. Consider a fifty-fifty growth/inflation Taylor coefficient set. What would you expect for 2021? It would depend on your target interest rate. If we assume that 1.75 comes from the coefficients set – granting therefore a leeway to shore up meager growth and assuming 10.5% expected inflation for 2021 – quite close to the current CBRT poll - you would come up with target interest + 1.75%. So, if you target a real interest of 3.8%, the current rate, you come up with 16% policy rate. This is the lowest it could get in a year or so in my opinion unless confidence is fully restored beforehand.