In a week of central banks, lira’s stability is key
After a period of appreciation that lasted for almost five years between 2003 and 2008, the lira began to depreciate after the collapse of Lehman Brothers sparked a global financial crisis.
Between March 2008 and March 2017, the compound annual growth rate (CAGR) of consumer price inflation was 8.07 percent, more or less equal to the consumer price index moving average in the last two years. This is over almost a decade, enough time in which to speculate that average inflation stands at around 8 percent.
Now, the CAGR of the lira’s depreciation against the dollar over the same time period is 13.02 percent, almost 5 percentage points higher than inflation. This is all the more significant since the pass-through coefficient hovered around 12 percent over that period, feeding into inflation at a significant rate.
In a nutshell, the lira has been depreciating but not continuously. There were episodes of stability and periods of rapid depreciation. Changing the metric - i.e., measuring the lira against a basket of currencies or the euro - does not change the qualitative argument. The stability of the exchange rate, whether it is openly admitted or not, is not only the main driver that explains economic and financial performance, but is also key to understanding Turkish monetary policy. Enter the Central Bank and its current stance.
Global central bank moves
Last week was a week of central banks. The Bank of Japan did not move, but the People’s Bank of China did, benefitting from the Federal Reserve’s anticipated rate
hike. That shows how China reacts to the United States and behaves globally.
Of prime importance was the Central Bank of Turkey’s likely response. The immediate reaction to the Fed decision was a lira appreciation, but will it continue? No, because both the hike and the lira’s response were in line with what was anticipated.
After Fed Chairwoman Janet Yellen’s recent speech last Wednesday, we knew almost for certain that the U.S. central bank would raise the interest rate in mid-March, an expectation that was priced in before the Federal Open Market Committee (FOMC) meeting. What’s more, we can safely assume there will be three rate hikes in total this year.
If the Fed moves as expected over the rest of the year - and this is what the FOMC members have been trying to say in the last few months in messages that explain its planned course - all Fed hikes will be priced in smoothly beforehand. And if the “Trump trade” (the rally in stocks attributed to President Donald Trump’s election) continues, emerging markets will benefit from that too. Interest rate hikes in an orderly fashion will still hurt since they are expected to continue into 2018 as well, but the damage is far less than any surprise move would have done. So much for the “secular stagnation” hypothesis of Hans-Werner Sinn and Lawrence Summers.
The stability of the exchange rate, whether it is openly admitted or not, is not only the main driver that explains economic and financial performance, but is also key to understanding Turkish monetary policy...
Inflation’s role in monetary policy
This is good news. I expect that, despite many claims, to the contrary, inflation will remain neutral from the standpoint of Turkish monetary policy in the near future. This is based on a few observations, the most important of which is the fading currency passthrough effect.
We know that the lira has depreciated against the two major currencies for the past nine years. The important thing to know is the timing of the depreciation cycle. Has it already depreciated too much to regain strength? I tend to think so on two accounts. First, the lira has already depreciated more than the trend for two consecutive years. Second, orderly and anticipated Fed rate hikes was the best that the emerging-market universe could hope for, and it is happening.
If the lira stabilizes, and given that domestic demand will not be buoyant after the April referendum, inflation will depend mainly on food prices. There are three major channels through which inflationary shocks occur: the exchange rate pass-through, food prices and oil prices.
Oil prices have already plateaued and the lira has depreciated substantially. Currently, year-end CPI expectations hover around 9 percent. Depending on the occurrence of a global reflationary spiral – given the “Trump trade” -that is a distinct probability. However, even better, inflation may stay steady at about 8 percent, its twoyear moving average.
Political stability to shape medium-term
Medium-term developments will depend on two things: political stability at home and in the region, and the future of Trump’s purported sea-change. The first depends on the result of the referendum to be held on April 16, although a “no” vote would not change much. After all, this is not an election, and all major political actors will remain in place. A “yes” vote would obviously imply the beginning of a new regime since the referendum is about constitutional change. However, it is not entirely clear what effect such an outcome will have on the conduct of economic policies.
Regional political risk could be mitigated if the United States and Russia can agree on short-term goals in Syria and Iraq, including Russia’s future stance towards Iran, assuming Trump’s possible cooperation with Putin would be conditional upon a partial dissociation of Russia from both Iran and China. Turkey ought to play a balancing role in all this or stay neutral.
These things may or may not happen in the foreseeable future, which redirects us towards cross-border financial flows and,
obviously, to the Fed. This is crucial for the moment, if only because predicting a politics-driven decrease in the country risk premium is not a likelihood we can bet on right now.
First, enter cross-border inflows. In the aftermath of the global financial crisis, emerging countries continued to tap debt markets, but with greater difficulty. The decline in the non-core liabilities of emerging economies’ banking systems was mainly driven by demand, as industrial production and gross domestic products crashed in October 2008. There was simply no demand for credit. The decline was also due to the pervasive uncertainty clouding the world economy. Risk premiums increased everywhere.
In the second phase, however, developed economies resorted to quantitative easing and committed themselves to near-zero interest rates, which jumpstarted the flow of funds toward emerging markets. As a result, new credit booms occurred and non-core liabilities grew by leaps and bounds.
In the case of Turkey, the new course meant two things. Equity capital began to grow 15 percent higher than its pre-crisis trend and kept to this course for many years after 2009. The reason was twofold.
First, the policy rate was cut from 16.5 percent all the way down to 6.5 percent, which implied considerable capital gains for Turkish banks. The growing number of non-performing loans were not allowed to wipe out net profits, since the Banking Regulation and Supervision Agency had cut the reserve requirement rate to 1 percent on lira loans and to 2 percent for forex-denominated loans for an initial period of three months, which was extended. Banks were covering 80 percent of non-performing loans. That made a huge difference.
Increase in corporate bank borrowing
Secondly, banks’ foreign funding increased from about 5 percent of total liabilities to about 22 percent within five years. Access to debt markets was quasi-automatic, and both corporate and banking sector debt increased rapidly. Emerging-market corporate debt be-
There is no sign of exuberant domestic demand ahead, but modest credit and asset growth of 15 percent and 1 3 prcent, respectively, in the banking sector are within reach. If the lira stabilizes after April 16, I would look to asset prices and multiples first, because exchange-rate stability is the pillar upan which everything depends.
came popular. The London money market was awash with corporate credit. Cheap and easy money caused domestic-demand-driven growth for at least two consecutive years. In a way, this continues, albeit at a much slower pace.
Could it discontinue after the Fed’s now-largely-factored-in three rate hikes in 2017? This again is the key to the situation above, and will determine the fate of Turkish debt and capital markets this year.
Note that after former Fed chairman Ben Bernanke’s May 2013 speech that started the “taper tantrum,” inflows turned into outflows for emerging markets. A study by the Turkish Central Bank shows that “the negative supply-push impact can be observed through outflows.” However, the same study convincingly claims that, for Indonesia and Turkey, the “positive demand-pull component of the movements in non-core liabilities dominates this negative supply push impact.”
However, this time around the growth of non-core liabilities is more likely to be driven by supply conditions, given that whatever demand there is reflects mostly either a lack of equity or a lack of new purchasing power. That will determine growth and, to a smaller extent, earnings prospects.
If these claims prove correct, we are looking at modest GDP growth of 2.5 to 3 percent along with a single-digit policy-neutral inflation rate. The current account deficit will rise a bit, but this should not be too impactful since it all depends on the oil price.
The major uncertainty surrounding the balance of payments is tourism revenue, which will determine the size of the current account deficit and, in turn, will have a bearing on how much reliance there is needed on reserves and net errors and omissions in financing it.
There is no sign of exuberant domestic demand ahead, but modest credit and asset growth of 15 percent and 13 percent, respectively, in the banking sector are within reach. It all depends on an orderly retreat. And if the lira stabilizes after April 16, I would look to asset prices and multiples first, because exchange-rate stability is the pillar upon which everything depends. That could provide a very good entry point indeed.