STOCKS, ASSET BUBBLES AND GROWTH

ROBERT SHILLER, Nobel laureate in 2013, had produced an argument and provided the public with accompanying data. Here is an old graphic that shows where the S&P stood in terms of the real composite index. The first steep increase corresponds to the 1996-2000 period. At that time, there was a debate about a stock market bubble, a debate that lasted almost five years. In the end, the ‘bubble’ burst but what indeed is a bubble or a bull market that extends 5 years? Now, Ray Parkes (Yale) conjectured almost 15 years ago that the reason for the drastic rise in multiples ( basically PE) was a direct consequence of foreign capital inflows into U.S. equities. The period would be reminiscent of 1981-1985 when the dollar had appreciated to such an extent that it was on par with the Pound Sterling. It took the Plaza Accord of 1985 to end this episode. At that time the reason for the dollar appreciation was flows to American Treasury bills because of the interest rate differential. American fixed income had become very attractive compared to the Deutsche Mark, Sterling and other major currencies in the aftermath of the Volcker deflation. Indeed, in June 1980 the FFR had hit 20 percent, the peak level in a century. Exuberance isn’t uncommon.

1990s

The story was different in the late 1990s. Back then, there was talk about the “new economy”, America conquering both inflation and the business cycle. So, it could become a ‘soft power’ at last. The real economy repercussions were also astonishing since the unemployment rate, to pick a key variable, had fallen to below 4 percent in 2000. After all, generations of economists had relentlessly emphasized the idea that the ‘natural rate of unemployment’ – NAIRU, Non-Accelerating Inflation Rate of Unemployment - was 6 percent. It couldn’t be expected to fall below this level. It happened though. Is this time any different? Are there reasons for a fundamentals-backed multiple expansion? I doubt it very much. Bubble or not, exuberance was present, definitely yes.

BIST 100

How about BIST 100? Consider another episode: PE was below its 5-year average by April 2017, and even that summer, the discount vis-à-vis other EMs was 10 percent by this metric. It had been oversold so to speak, and to a large extent the boom that followed was also due to cheapness. The lowest PE was in Russia by the end of April, Turkey coming up next. It wasn’t multiple expansions per se but volumes that drove the index back then. The global asset prices went up to historic heights, and mostly due to that, the BIST also benefited. But in dollar terms it was again far from nearing the 2007 level for instance, just as it is now. So is the index truly heading north now? The radical difference lies in the behaviour of non-residents. They have been selling off. If this trend continues, the stock exchange will be more and more confined to residents’ transactions, and it will co-vary less and less with other EMs and such. Besides, EM stock markets are not the primary locus of what has been going on in terms of multiple expansions. U.S. markets are.

FX DEBT

The first policy problem concerns developed economies and some developing economies that have low levels of F► debt or don’t depend on commodity exports or tourism. This is a monetary policy issue. Just how long and how deep should easing be and should nominal interest rates turn to negative? The U.S. won’t resort to negative nominal rates so easily, although even that is on the table.

The second problem is a balance of payments issue. Countries where capital flights abound and reserves are low or exports leave to a lot to be desired or tourism falters face that problem. In such economies the real rate of interest is of prime importance. Monetization won’t necessarily trigger demand but it would help. There may be an inflationary aftermath if sterilization leaves a lot to be desired, but this is conditional upon a truly recovering demand. Nonetheless, negative real interest rates can distort equilibrium. •verseas investors continue selling – $670 million in the week of June 5-12. Non-residents now hold 52 percent of equities and 5 percent

of bonds, the lowest over the last decade. Also, the ex post real rate has ordinarily been below the ex ante rate. This means inflation has consistently been above expectations. The 12-month real rate is deep in negative territory. Faced with the second type of (currency) problem, there is no way negative ex post real interest rates can do the trick. Even ex ante they are negative. Negative real rates aren’t suitable if one is in dire need of foreign currency. The exchange rate can only temporarily stabilize given the loose policy stance. Capitalizing public banks is good, but is it wise to continue selling precious reserves? •ne thing is certain though. Tourism revenues will be very low. Net exports will fall relative to 2010. Suppose these two items amount to $35 billion. Add to this falling swap volumes, and reserves sold, and you come up with a sum total of at least $80 billion. Well, what next?

DOES AN IMPROVING TRADE BALANCE 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, not because of its large foreign asset holdings, but because of its large F►-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 provide an account of how international competitiveness unfolds. The current account only showcases the amount of F► needs on a monthly basis. The financial account, including valuation effects, determines the final verdict.

WHY CAN’T WE GROW?

There can be no sustainable growth because of one thing and one thing alone: earnings are low. Earnings are low because productivity is low. Profits are also low because firms are heavily indebted, in both F► and TRY terms, and EBITDAs don’t translate into the bottom line to shore up equity capital. Because equity capital is weak, debt takes its place 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. Because the financial account is deteriorating, growth is falling. They go hand in hand. Because the financial account is going sideways, reserves are being depleted, except of course episodes of somehow booming net errors & omissions. FDI is nothing compared to the financial account.

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.

The private sector itself struggles 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 7 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. And yes, there will be a kind of revival after the initial C•VID -19 impact, but this shouldn’t be confused with sustainable growth.

CAPITALIZING PUBLIC BANKS IS GOOD, BUT IS IT WISE TO CONTINUE SELLING PRECIOUS RESERVES?