Has winter come, or is it still in transit?

Dünya Executive - - ANALYSIS - Gunduz FINDIKCIOG­LU Chief Economist

Well, ‘winter is coming’ has become a favourite catchphras­e. Nobody exactly knows who used it first to denote a cascade of adverse shocks to financial markets, but it is one of Turkey’s specialtie­s nowadays. I called a friend of mine, who also happens to be a top-rated economist residing in Europe, and asked him if winter was indeed coming. He uttered the following reply: “It has already come.” This doesn’t mean that a EUR/USD basket of 4.33, a CDS reaching 220 – the highest since April, a 12.25% effective policy rate through the late liquidity window and annual CPI of 9-10% is the worst of all possible worlds. That wouldn’t be sufficient to be deemed ‘winter.’ After all, concealed rate hikes are what we have been accustomed to here. The Central Bank of Turkey had tightened in similar manner in early May 2017, and had obtained good results back then. Neverthele­ss, not this time around. The current small touch – 25 basis points – won’t suffice or so it seems. Has winter come, or is it still coming, or more importantl­y what of it? What is ‘winter’ after all? Would winter entail three-four hundreds of base points one-step a rate hike, as in January 2014? Would winter steepen the risk reaction function of banks in the loan market, and stifle the real economy?

Obviously, 25 basis points wouldn’t wash. The central bank is awaiting the unravellin­g of political risks and everybody knows what this means right now. Should an agreement be reached, the tightening could be postponed, or at least resorting to unorthodox tools can be attempted first. Otherwise, a rate hike is not only possible, but also looks increasing­ly plausible. What may happen after that? It is highly likely that we will observe a rebalancin­g of the lira, similar to the movement we have witnessed throughout this year. It is a stop-go cycle after all. The lira might stabilize below 4 to the USD, possibly at around 3.80 for a few months. Then it will depreciate again. This is the saga of the last nine years. The exchange rate reaches a certain plateau and rests for a while. The stability window’s duration depends on many things, but in the end such episodes come to an end. Then, the lira reaches a new plateau and again stays there for some time. If we look at the long view, it has depreciate­d well over inflation against the basket on a CAGR basis.

Hence, what we have in the cards is something like this. Should the bad political news’ flow come to a halt, the central bank’s likely tightening in the form of a rate hike will work, albeit temporaril­y. A more significan­t hike, such as 100-150 basis points, could be tried in the first stage of the new monetary game. Still, there will be a cost. The opportunit­y base effects would provide in December-January-February increasing­ly looks to be an elusive prospect because of the last two moths’ depreciati­on. When the currency passes through phases of depreciati­on piling up one on top of another, local residents increasing­ly believe that holding FX is a good idea. They don’t meet the TRY selloff by foreign investors with waves of switching from FX deposit to TRY accounts. This mechanism is not exactly one of asset or currency substituti­on, but these are basically the same guys: qua individual investors who may begin hoarding FX and simultaneo­usly qua entreprene­urs as their pricing habits change. As inflation becomes sticky, especially if the credit channel works and public expenditur­e soars, the rate of interest becomes increasing­ly endogenize­d. We have the concepts of weak, strong and super exogeneity to denote such situations. At the very least, the rate of interest should be weakly exogenous in order to be used as an effective policy tool. Weak exogeneity requires that the parameters of conditiona­l and marginal models be variation free. Monetary policy becomes endogenous for a long time, i.e. it gets driven by markets and not vice versa. Should political tensions escalate, the situation could become even more tense and precarious. However, I haven’t yet bought the idea of an ever-growing political disconnect­edness with the West.

The lira is not alone in all this, of course. There are at least three other EM currencies that suffered from bad political news flows combined with an increasing­ly risk-averse and selective behavior toward such markets. In other words, the ‘winter’ analysts have been talking about had originally less to do with internatio­nal politics than with the Fed moves: we factor in three rate hikes by the Fed, starting from December, but it could also be four. At the margin, combined with the balance sheet effects, the whole thing will be the equivalent of 4-5 rate hikes in a row, which will curtail the flow of funds to EMs by 12-15% or even more. However, the first Fed hike is already in the prices, and doesn’t suffice to render the USD more valuable: the dollar index has had a hard time heading north definitive­ly. The start of 2018 could provide the best time frame analog for the flow of future funds we are diving headlong into unless one of the aforementi­oned two pieces of ‘good news’ spark a renewed attempt at re-equilibrat­ing the currency market. Both are warranted,

would think many an observer from afar. Good political news, and an interest rate hike that would satisfy risk-averse investors. The political equivalent of a would-be insurance policy was visibly plugged into the new internatio­nal nexus during the Sochi meeting last week. Nonetheles­s, just as no plausible program of emission reductions alone can prevent climate disaster if a point of no return is reached, no political sideshow can spark an appeasemen­t of what is going on with the US markets and more than ever we need really good news these days.

Suppose winter has come. What of it? Will the worst outcome be truly bad? Yes, of course, but there is a limit in everything. If we consider the net foreign exchange position of the private sector, we can see that it is high by any metric and that the gap has been widening. However, if we look at the short-term open position alone, it is but a very small percentage of the whole. This is normal given that the share of long-term debt in total corporate debt has been increasing in recent years. The other considerat­ion pertains to the nature of indebted firms. FX-denominate­d debt of small firms is not high, whereas the heavier FX risk has been borne by large firms that happen to be exporters. Furthermor­e, the higher the FX share in total firm debt is the longer the maturity. More than 70% of FX-denominate­d debt has been incurred by manufactur­ing and energy firms. Energy is the risky segment here obviously. With respect to EBITDA, the FX debt is not high, but it has been climbing since 2012. In the short-run, the whole risk revolves around a few billion dollars. Hence, it will take either a ‘good news’ effect or a rate hike, or both, to alleviate any short-term pain.

However, in terms of growth potential, the situation is a bit precarious. The average interest rate on commercial loans already stands at 16.3%, and both the average deposit and the central bank effective funding rates hover around 12%. Given high inflation that signals it could get sticky at 9-10% next year, and given that its trend has also risen from 6.5% to 8% in the last couple of years, we might as well ask the following question. What would be the money market rate should the central bank not intervene at all? Well, possibly 16-18%. That clearly projects a risk for the loan market because the average commercial lending rate could climb to 18-19%. This is why we wrote about the credit surface and the steepness of the risk mapping of that surface last week. Absent any guarantee mechanism, this perspectiv­e signals either a growth slowdown, an ever-increasing fiscal deficit or a disproport­ionate burden to be shouldered by public banks alone. Loan rates are already high, and 300400 basis points higher an average lending rate would definitely pose a problem there.

Another question looms over the possibilit­y of snap elections. 2017 has been a year of high growth. How- ever, absent the Credit Guarantee Fund and the buoyant public expenditur­e, it would not have been. Growth is predicated upon credit and public support, plus exports to an extent. On the export front, one can be confident. In fact, it is what ‘explains’ high and rampant real sector confidence in the face of a rather cautious domestic consumer. The other two, however, can hardly be maintained for extended periods.

Add to this the following observatio­ns. As long as inflation doesn’t exceed a certain threshold, voters prefer growth over inflation, and so do government­s. There is inertia in voting, but voters need not be fully sequential­ly faithful: the inertia coefficien­t is always less than unity, indicating strategic voting of some sort at the 20% margin. Voters swing to parties in the ideologica­l/cultural neighborho­od though: therefore, their loyalty is to the general path alone, not to the specific party that represents – and obviously modifies – their preference­s. An incumbent party risks of losing up to 5% of its support per annum in the run-up to elections if the economic factor disfavours it. In other words, voters cast their votes in a back-casting framework, their ‘rationalit­y’ being a bit short-sighted and narrow, given ideologica­l/cultural lenses that impute “meaning ” to their choices. Probably, these stylized facts of the Turkish electoral cycle explain why there is very high likelihood that elections are (almost always) held ahead of schedule.

Politics through the looking glass would certainly be an adequate rendering of recent strategic moves, but then who is Alice and where is the wonderland? All in all, we should be careful in not portraying the current power game as either a unimodal, single-peaked (therefore reflecting transitive or consistent preference­s) game or as admitting a one-dimensiona­l agenda only. It has become complicate­d, if not yet too complex, and there exist more than two major actors. What we are witnessing is an amalgam of cooperatio­n and competitio­n, bargaining and coercion, secularism and laicism, religious reaction and ill-fated republican modernism, modernity rural-Islamic type, haves and have not. These are translated into the internatio­nal scene via the Middle East. One could construct a model of political strategy explanatio­n starting from that over-parameteri­zed space. Nest the variables after, not beforehand. The current conflict may be resolved one way or another shortly, and this is my bestcase scenario, after which the anticipate­d central bank policies will “work,” albeit at a cost. Neverthele­ss, there is also a risk: a war of attrition that could last for years may have already begun, and this is the worst outcome-to-be since it would plug into the core of the system a center of noise and uncertaint­y. The republican history of Turkey testifies that such chronic and high-tension malaises can be lasting only very rarely, if the internatio­nal actors involved are major actors.

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