The survivalis­t: growing pains or what?

Dünya Executive - - ANALYSIS - Gunduz FINDIKCIOG­LU Chief Economist

Growth endures. The Credit Guarantee Fund (KGF) has run its course, and made c. 5% GDP growth possible in 2017. The ongoing loan cycle points at both facts: that it did work and that it has now ended. On the other hand, high levels of public spending were a constant factor of economic life. Actually, the contributi­on of public expenditur­e turned to negative in the last print, but only after having provided eight quarters of continuous impetus to growth. It has risen fast in 2017, and we have already conjecture­d that the spending cycle should come to an end if the monetary policy/fiscal policy mix is to change.

Tough to cut nterest rates

It is difficult to cut interest rates even when the right time comes unless the fiscal front is secured. If the last print signals a turning point, it can be seen as a good omen because the meteorical­ly rising fiscal deficit-to-GDP ratio – although the net public debt-to-GDP ratio is low and the fiscal deficit ratio was also low until this year; so, there was and is some slack there – could eventually have a negative impact on the risk premium. If internatio­nal investors’ risk premium for Turkish assets can be kept low even at a (future) time when the risk appetite and risk tolerance thresholds for emerging markets (EM) change, funding costs and interest rates can also be contained at an acceptable level. “They are already high,” some would say. It is true and even more so given that mortgage rates for instance are going up as we speak. Obviously, it depends on your view of the world-to-come to some extent. Clearly, if you still think the secular stagnation hypothesis holds, you might naturally consider that even in 2018 a rising USD – and euro – interest rate path is an unlikely event. Neverthele­ss, if you believe that a financial cycle drag exists, you might expect a normalizat­ion of monetary policies going ahead even though it takes time, and central banks are not eager to tighten their belts. If nothing much changes in Q1 2018 in terms of global debt markets’ pricing, and funding costs don’t rise, then all the better then there may be a window of opportunit­y to switch the monetary/fiscal policy mix here. Inflation will fall during December-January-Feb- ruary if only due to the base effect. The combined setback can reach at least 200 basis points. It looks like the optimal timing for monetary easing lies ahead, and any move to cut the effective funding rate before that happens will be counter-productive. In fact, the Central Bank of Turkey behaves in conformity with this understand­ing. It didn’t change an iota last week.

Important deeds on the hor zon

That much is obvious but in the end, if the US equilibriu­m interest rate is not near zero, i.e. if it is positive and significan­tly higher than the current level, however long the Fed drags its feet, in the end interest rates will continue to go up and the balance sheet will contract all the same. The ECB will also change its stance and tighten. “Forward guidance” has been used many times in the last few years, but it is becoming ineffectiv­e each and every time it is resorted to. Deeds more than words will count at some point, and that point is not far away. Smooth transition to a new equilibriu­m is all that counts for the major central banks that act at least implicitly in concert.

Equ l brat on process to take t me

On the other hand, the euro is most probably at a peak level against the USD. There is kind of an “overshooti­ng” there, and the dollar index is more likely to start increasing than not. What matters is to prevent a meteoric decline in the EUR/ USD exchange rate, and not cause a turbulent volatility increase. Starting from now, we may go down the EUR/USD path, but not as far as below 1.10. The equilibrat­ion process will take time if only because the central banks prefer that smoothness. We may see that in Q4 2017 or in Q1 2018 at the latest. If inflation in the advanced economies will rise, interest rates will necessaril­y go up even in the absence of any other reason. Furthermor­e, there are other reasons. As a BIS document puts it, “defining and measuring an equilibriu­m rate without explicitly considerin­g the build-up of financial imbalances is too narrow an approach.” Unless demand is truly deficient, which doesn’t seem to be the case given the current states of both the US and the Eurozone economies, not to mention China and the rest, the equilibriu­m interest rate is bound to be higher in those regions. What this implies is that the long-awaited EM corporate debt re-pricing is in the making. The re-pricing curve can be rendered less steep than it would otherwise be as a result of policy coordinati­on by both banks, but it will happen. Still, we take this cautious approach not because we think an imminent and drastic interest rate and funding cost rise lie ahead, i.e.

in a few months, but only because a (hopefully tolerable) global interest rate increase is a distinct possibilit­y. This squares with the view that prior to the Lehman crisis, it wasn’t inflation that ran rampant as a result of the credit cycle and buoyant demand, but property prices and financial asset prices that boomed instead. Banking crises that go hand in hand with macroecono­mic imbalances and real business cycles tend to produce the longest lasting nefarious effects on economic conditions.

Factors beh nd Turk sh econom c surv val

The survivalis­t? This economy has made a habit of surviving in the face of adverse conditions because of two factors. Firstly, there is always a funding steam that somehow pours in. Either the EM universe is awash with liquidity or there is a local financial injection of some sort – the KGF is a case in point and at one point we had thought the same way about the Turkey Assert Fund; anyway, the case is not yet closed – or the net errors and omissions item comes to the rescue. Secondly, there is always demand although earnings stagnate and so, recently, has labor productivi­ty. Because there is wealth in the nation – although not enough capital so capital is still the scarce factor – and because the population is still young and suchlike, there is always extant or latent consumer demand that can be triggered. One reason is the stilllow share of mortgages in consumer credit; the other is the low duration of mortgages. No household is tied for 30 years or so; hence they can always tap the consumer credit market. Obviously, we are far away from 2004 when the whole process started, and the household is heavily indebted now vis-à-vis its own past, but not compared to Europe or the US.

Recurrent loan cycles

The Q2 GDP data looks more equilibrat­ed than the Q1 data. Even so, the capital formation item reveals a high concentrat­ion on constructi­on. That may be well founded because real estate developmen­t and constructi­on are widely used as capital accumulati­on devices. To some extent, that can be considered as normal since, after Piketty, we know that in the production function real estate took the place of land. Hence, up to 40% of capital accumulati­on came from real estate even in the advanced world during the 20th century. However, an over-emphasis on a single factor of production is not warranted, and is subject to decreasing returns. Furthermor­e, and this is a lot more important – even decisive in the longer run – the interactio­n of an over-extended financial sector with the real sector has produced recurrent loan cycles. Loan cycles are debt cycles, and the “hypertroph­y of finance” so to speak is not the same thing as financial deepening, which one would encourage. Credit booms tend to undermine productivi­ty growth. This happens because resources are misallocat­ed towards low productivi­ty sectors such as constructi­on in an overt and prolonged way. So, there is a price: one can manage to prolong the life of unproducti­ve companies for some years, thus maintain unemployme­nt at a politicall­y tolerable rate, but only at the cost of resource misallocat­ion and productivi­ty slowdown. Once credit is tied, it is not easy to redirect it to other sectors, especially after a loan boom. The KGF’s supply-side “hysteresis effect” will perhaps be measured properly in the coming few years. It worked, but there is surely a long-term cost.

The three messages of GDP data

So, the survivalis­t has already survived 2017. GDP data conveys three messages. (i) The contributi­on of public spending has been negative, and although one single datum cannot as such pass for a sufficient statistic, it may signal a moderation in spending. If so, then fine. (ii) A related feature of the data is the continuati­on of net exports to GDP growth. The contributi­on of external demand has been 1.8 points, which has come on top of Q1’s positive datum. Europe has significan­tly recovered and Turkey’s exports go up. This may be extremely relevant because whenever net exports don’t contribute, the whole burden is on domestic demand, and hence on incentives and the credit channel. Since c. 70% of Turkey’s GDP is accounted for by consumer demand, it is impossible for the country to rely exclusivel­y on exports. Nonetheles­s, if exports continue to perform, there will be kind of an equilibrat­ion between sources of growth. There is a clear link between fiscal moderation, increasing exports, and the debt rollover ratio of the Treasury. That also matters when it comes to monetary easing because you can’t easily get the banking channel providing comfort in the desired direction if you don’t stop squeezing Turkish lira liquidity in the market via over-burdened Treasury auctions. The central bank will revise its reserves policy also – or so we think. Otherwise, we may observe a period through which banks will use the reserve option mechanism more and provide the same effect. (iii) Consumer spending has contribute­d much less than before. Even so, industrial production increases and the fixed capital formation are high. That may well point to a new pattern with desirable characteri­stics. In Q3, although the loan cycle is now over, and loan growth fell to below 20%, GDP growth may stay high. In Q3, GDP growth will be higher than Q1 and Q2 anyway because agricultur­e will play its role and more so, because there is a strong base effect. We expect to see a change in the “credit boom/public spending-driven consumer demand buoyancy conducive to high growth” pattern. Exports count for much here. In fact, consumer confidence/sentiment and industrial confidence go in opposite directions. Exports should be the main reason.

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