Exchange rates, oil prices, rates, and politics
What is going on? The ‘short electoral cycle’ was welcomed at first because market plays thought imbalances would be kept at minimum. Then, the rating downgrade came, and the government announced a package including pro rata payments to the retirees and so on. At that point, April inflation sealed the short-run, attracting attention to deteriorating core inflation signals, an unclear fiscal position that blurs the picture, and the CBRT rate increase has been neutralized. Add to this the IMF IV Article Consultation report that once again emphasizes ‘overheating’, rising oil prices and the picture is complete. The secondary market benchmark rate jumped along with the exchange rate amid fears of rampant inflation. It went up from 14.20 percent to 15.23 percent in two weeks, and from 13.22 percent to 15.23 percent year-to-date. The EUR/USD basket is at 4.677 up by 12.5 percent since the beginning of the year. Clearly the market drives both the interest rate and the exchange rate up as it follows a data generation process that keeps the real interest rate above four percent. The 12-months expected real rate is now at 4.29 percent up from 3.75 percent in December. The real rate rises because the risk premium increases. The nominal rate goes up because both the risk premium and inflation expectations soar.
Inflation increasingly comes to the forefront as the prime mover. There are at least three arguments here. First, Domestic PPI and the exchange rate go hand in hand, and because demand has to be always ‘incentivized’ and triggered ahead of elections, CPI inflation is expected to adjust to the PPI inflation and not vice versa. Second, oil prices also have a bearing on the PPI although the link is less obvious because of taxes that might act as a buffer zone, but that ordinarily act in the opposite direction when prices are low. So, it is not because the link is in fact weak but it is sometimes broken due to tax policies that it appears weaker than it would otherwise have been. Third, core inflation is now sticky and in fact it is quite stubborn beyond stickiness. As the lira continues to depreciate there seems to be no other direction than an upgoing core index. Hence, although non-processed food acted in favour, the CPI print has been higher than expected. Analysts now pen in a 12 percent peak CPI by the end of August, but even this is unclear. Any peak between 12-15 percent is as much likely. Once inflation peaks, I think the ex ante real interest rate and the ex post rate will approximately coincide, and any above four percent real rate would do from then on. This suggests the secondary market benchmark nominal rate still has room to go up unless expectations are anchored in the aftermath of the elections, which brings us to the IMF Article IV.
The IMF is ordinarily known for being a latecomer either because its reports are published after the event or because they voice concerns that are averaged out through the Board diplomacy. However, the typical IMF wisdom con- veyed through Article IV seems to be timely this time, because there are two pillars that kept the momentum going in Q1: Bank borrowings from overseas were resilient and the fiscal policy seemed to have some room to go. Because elections will be held early we thought the fiscal view would be kept intact, i.e. without further deterioration. However, things have all of a sudden changed. The two TRY 1000 bonuses alone will bring a $5.63 billion deficit to the budget as the current exchange rate goes. This is roughly equal to the 2017 total central budget deficit and can be expected to more than wipe out the primary surplus. This is obviously only one item, other amnesties and incentives are liable to further disequilibrate budget dynamics going forward. The usual IMF recipe goes along the following lines: tighten up, restore confidence, keep budget discipline – or rejuvenate it - stabilize the currency. Then, get back to fundamentals and announce ‘structural reforms’ whatever these may be at that time. Now, monetary policy has not been extremely tight in 2017 and 2018 but it is tight now, not extremely tight, but tight nonetheless. In fact, a slowly forming currency substitution trend puts serious constraints on monetary policy and, once in place, it is difficult to reverse course in asset substitution. However, assuming confidence is back due to conventional and simple monetary policies and sound fiscal standing after the elections, both the flow and the stock of FX would begin to point to an excess supply. One policy option would then be – after a year or so of lasting severe tightness - to reduce interest rates, fuel domestic demand and absorb the excess supply by the resulting surge in imports. The other policy option would be to keep interest rates high and let the CBRT buy the excess
supply. With the passage of time, reverse currency substitution may either serve to finance the current account deficit or to pay back foreign debt. This is the conventional “policy reversal” story. Reality can prove to be somewhere in between.
Would a front-loaded monetary tightening and a disciplined fiscal policy do? I am not sure. There is an inflationary momentum now and it in fact helps corporate earnings. It will have to run its course, which will take several months. Then, because both high interest rates and the ever-rising exchange rate hit different segments of the corporate world, there will be a choice to be made. An inflationary spiral, if it is fully formed, isn’t a simple problem to deal with. All sorts of fiscal and quasi-fiscal measures will have to be taken, plus a centrally orchestrated total plan will have to be announced assuming political risk goes away. There is also the possibility that time can be bought via toying with half-measures, but to what end I can’t guess. In short, the overarching authority has to decide what to do next with a long-view perspective. Otherwise, because I still don’t adhere to the ‘overheating view’, the economy will be left to cool off by itself after the elections. It will ‘equilibrate’ in terms of ‘overheating’, and the growth rate will be down to below potential – but by how much? Now, ‘overheating’ can mean two things. Primo, a significantly above potential growth that generates imbalances of sorts, and secondo, an economy that is forced to ‘overheat’ through upbeat incentives. It is difficult to measure the potential growth rate currently; it could be as high as 5.5 percent or as low as 4.5 percent. Take 5 percent and still 2018 GDP expectations fall short of this threshold. So, it will be automatically cooling off either way after the elections.
I take the election results for granted and offer the following ar- guments shoring up the “automatic coolant” story that I have been trying to elaborate. Admittedly, this is a bit of resume adding up some insights from the political economics literature. I take it for granted also that the current electoral cycle we are witnessing is one of the last of its kind. Why? To begin with the obvious: the claim that parties that locate themselves at the centre, centre-right or centre-left included, have a priori much more chance of winning any election is ubiquitous. The specific analytical proposition that endorses this colloquially widespread understanding is called the median voter theorem (MVT). Knowing what it precisely means matters because the MVT is the cornerstone of many a research that lie at the frontier of political economics. Admittedly, the MVT is a Nash equilibrium, and its validity depends on a few assumptions, most of them unrealistic. People experience the victory of the centre in many elections in a lifetime and iterate in the vernacular that extreme parties have small chances of success. What they mean, or rather “should mean”, is nothing other than they refer to the MVT and implicitly assume the conditions that empirically validate the MVT are indeed present. But there are many political configurations in which a variant of the MVT may hold, and other environments in which it never holds.
So far so good, perhaps, but what is my point here?
It is that to generate empirically testable propositions and provide answers, if not in terms of causality at least in terms of finding robust correlations, political economics ought to start with theoretical sentences and divulge into specifically construed models that conjure up into an analytical instrumentarium and generate robust empirics. Micro-econometrics and game theory meet each other on this new terrain. And there are some remarkably well-founded and empirically testable – indeed tested and still being tested - propositions propagated by political economics. Below I list some. The most important results are. (a) Presidential and majoritarian systems have smaller governments than parliamentary and proportional representation systems – where government size is measured as government spending as a fraction of GDP. Majoritarian systems also appear to have smaller welfare state spending and budget deficits. (b) While presidential or majoritarian systems in general do not have a robust effect on political rents, corruption and aggregate productivity, certain details of the electoral system, in particular the size of the electoral districts and whether voters cast their ballots for individual politicians or for party lists, do have significant effects. (c) Countries with parliamentary systems have more persistent fiscal outcomes than countries with a presidential system. Namely, in parliamentary systems, increases in government spending during downturns are not reversed during booms. There is a similar, but weaker pattern, for countries with proportional representation relative to those with majoritarian elections. Finally, consistent with the predictions of the political business cycle models, proportional representation also appears to generate a greater expansion in welfare spending in the proximity of elections. Because the political system changes, in terms of both welfare state properties, as desiderata go, and budget discipline, Turkey will have to evaluate pros and cons of various democratic sub-regimes in the foreseeable future and political economics can only help on these scores.
There is an inflationary spiral that has been forming up. It is interesting to note that a conjuncture where both the interest rate, the exchange rate and the inflation rise hand in hand is hard to find. It will take a more complicated approach than the IMF standard recipe to deal with its repercussions, but on the fiscal front at least, political economics suggest realism could set in later in the year.