Divergence, big time or what? World interest rates and a permanent KGF

Pre-1715 data is dubious, but in line with land prices. By the end of the early modern period, longterm rates hovered around 11%, but fell to 3% in the 18th century. Rates were never particularly high, globally speaking, in the longterm. But they were exceptionally high through the mid-1970s, that is after the first oil shock of 1973. This is also the start of financialization and a new era of changing attitudes towards social conflict. Not only did income and wealth distribution become tilted in favor of high-income groups, but wages and the nature of work also changed. It is clear that low rates for a period extending over a decade is a good recipe for innovation. It did happen just before the first Industrial Revolution, and it is probably happening now in the form of Industry 4.0. In fact, real interest rates have been decreasing for the last 30 years. Since 1990, real rates have fallen by 2 percentage points in every decade, and world real interest rates stood at (near) zero in the last few years. Hence, the “new neutral” was put to the test: zero real interest rates for years to come, or what? The policy is only now beginning to normalize. Yet real rates in the advanced world will never be as high as before for a long time to come. In fact, what kind of interest rate could trigger innovation and growth, if they are to go hand in hand to be sustainable? Hence, low real rates have a bite. However, this is not the end of the story; it could in fact only be the beginning. If you don’t do anything, however, no matter what interest rates are, you achieve nothing. Just temporary breaches of sparkling consumption-based growth episodes can occur if rates are low enough, or if there are other trigger mechanisms put to work, but the quality of life and work doesn’t change.

Could the KGF again stimulate growth?

Consumer confidence has been heading south for the last two months. What was a (perhaps) onetime slowdown has already turned into a tendency. On the other hand, the real sector looks confident. We had already pointed to that decoupling on the data corner page. The only explanation lies in the expected export performance. Unless the private sector anticipates an export boom, this kind of decoupling doesn’t make much sense. Otherwise, there ought to be a mechanism that will trigger consumer demand again, but I was unaware of its existence until recently. I am referring to the Credit Guaran- tee Fund (KGF) that now becomes permanent. Will it work again? If you look at the BIST’s Banking Index’ initial reaction, it might. There are risks though. Worse still, the real estate boom that had lasted many years seems to have reached its limit. Because in the new GDP series construction accounts for most of capital accumulation, this can be the source for further unpleasant arithmetic. What can happen next?

Loans and government spending have been the two pillars on which consumer demand was built. Because household debt is high, and because the real estate sector’s cash-flow doesn’t easily flow, real sector confidence is based on exports and stock depletion. That cannot continue forever. Making the KGF permanent is the purported answer to this situation. Exports cannot provide the answer because the domestic market is large, and domestic consumption accounts for at least 70% of GDP. Also, the value added that accrues from exports don’t exactly square with the contribution of exports to GDP, given the trajectory of the terms of trade, which are declining. Quantities say something, refinements over raw data another. That also can only be temporary. Now we know that the KGF did a good job, albeit in a transitory fashion. Admittedly, such shock therapy could only be transient, but now it may be built into the system. It helped SMEs to roll over their debt, it also helped them to secure working capital loans. It may even have led to loan hoarding because it was cheap, an opportunity firms couldn’t miss even if they didn’t exactly need the credit. If it becomes permanent, it would invite a moral hazard obviously, and could even lead to ‘zombie protectionism’ of some sort. Protecting jobs is a good aim in itself, but extending the life of inefficient firms comes as a by-product, delaying therefore much-needed restructuring of the small-scale enterprises.

Limited FX damage

Another important move is the appointment of Jerome Powell as the new Fed chairman. Amid rumors surrounding the nomination process, the Fed’s recent stance has passed almost unnoticed. However, we have every reason to pen in three interest rate hikes until the end of 2018, the first due in December. That is also news, but the best part of what has been going on is the decline in foreign currency reserves held by local residents. The lira has lost value in the last two months to such an extent that it is the second worst performer after South Africa’s rand. In fact, in October TRY was the worst performer, followed by the rand and the real. It depreciated by 6.53% against the dollar yearto-date, and by 19.75% against the euro. This means 13.14% depreciation against the 50-50 basket. This kind of depreciation is over the CPI inflation by c. 3 percentage points. Despite the

fact that the TRY-USD exchange rate hovered around 3.55 for about six months, in the end it also depreciated against the dollar, not only against the basket, as the Dollar Index went north. Because local residents are not piling up dollars this time around, the shock is absorbed to some extent, which currently limits the damage.

Easing monetary policy so difficult

The three FFR hikes consensus estimate currently implies 3.11% US T-10 years yield because the spread between the FFR and the US T-10 years stands at 1.21. It was 0.94 at the lowest, which gives us an interval of 2.84-3.11% for the November 2018 US T-10. While the US T-10 doesn’t exactly stochastically dominate the USD-denominated Turkish eurobond or the long end of the local TRY bond curve, it did exceed the spread change in the past. There is also always the Phillips Curve argument, and it looks subdued compared to the past. In the US, wages usually push inflation, but as time goes by, the push is set at a lower level. This is one of the main reasons why it took so long to raise the FFR, in addition to the asset market repercussions of an early hike. At last, hikes are coming. If we remember the ‘taper tantrum’ of 2013, indeed both the hikes and the balance sheet contractions are coming rather late. It took almost five years to really turn the tide of monetary policy in the north. The reasonable take away from this development is therefore this: Unless both inflation and the country risk premium fall, there is no way TRY interest rates will decline next year, except for temporary episodes. Given the inflation path, it will be so difficult for the Central Bank of Turkey to ease monetary policy in the foreseeable future, extending well into 2018. The ‘window of opportunity’ we had mentioned for monetary easing, because inflation could fall due to base effects in Q1 2018, looks increasingly elusive.

World growth is back

Therefore, the need for incentives to sustain domestic demand endures. It can only come from loans, government expenditure and the Credit Guarantee Fund, given that cutting interest rates is not currently doable, and maybe in 2018 as well. Now, government spending cannot go on because it would lead to a rise in the country risk premium, a theme we have explored quite a few times in the last months. Furthermore, spending is not a oneway street, it requires revenue. As revenue comes in the form of rising taxes, it also has a negative effect on disposable incomes. Lending at breakneck speed is not possible either, especially at a time when normalization of world interest rates looms large on the horizon. True, as Andrew Haldane of the Bank of England has put it, the US GDP is still trending 13% down on its pre-Lehman level, roughly half of the loss that American GDP had suffered 10 years into the 1929 Great Depression. Furthermore, the real cost of government debt has increased more than it did after 1929 in the same set of advanced countries, a fact that accounts for much of the reluctance to use fiscal policy effectively since 2008 in Europe and the US. Even so, in the US and the UK, government debt soared more than it did after 1929, but not in Germany and France. However, growth is back, and even England rose its policy rate for the first time in a decade last week. The compromise lies in the KGF perhaps to see whether, venturing into the “winter is (not yet) coming ” rhetoric, the “Indian summer” can be upheld.

The foreign currency risk profile of SME’s attracts attention all too often. C. 70% FX debt lies in manufacturing and in the energy sec- tor. Tiny firms are in general not indebted in foreign currencies; larger firms are but their debt maturity is rather long. Compared to EBITDA, debt was not high until 2015. However, it has been creeping up slowly but surely since 2012. Rating agencies may issue warnings, but corporate and SME debt’s foreign currency profile, maturities included, is not truly alarming. However, further FX debt is clearly unwarranted, a fact already signaled by the government. Here again, construction and real estate are the most heavily FX indebted sectors relative to EBITDA. Momentum is more important than corporate FX debt.

Several highs present real danger

On top of signs of slowdown, inflation is still stubbornly high. Not only has Turkey’s central bank raised its estimates, but there is also now a non-negligible probability that inflation will not easily fall despite the base effect that lies ahead. The c. 3 percentage points basket depreciation will take its toll on that front too. The Domestic Producer’s Price Index is also at its monthly peak with 17.28% year-on-year. It stands at 14.77% if the annual moving average is taken into consideration. At 11.90% the CPI is at an all-time high since Lehman. Core inflation is also rising: it is now up from 10.98% to 11.82% in a single month, the highest level since January 2004. Inflation is widespread across sectors and looks well entrenched. The base effect of the coming few months might provide some relief because we have had 2%, 2.98% and 3.98% respectively in November and December 2016 and January 2017. Still even 9.5% looks evasive now for year-end. It will fall due to the base effect, but then what? Especially intriguing will be the behavior of the exchange rate, but pricing behavior may have changed also, and therein lies the real danger. Loan, deposit and bond interest rates are very likely to remain high for an extended period.