Housing, exchange rate, flow of funds
Currently, the financial outlook isn’t bright at all. The CBRT’s move could have been effective, and saved EUR/USD parity; the USD/ TRY rate might have been down to below 4 two weeks ago. However, the electoral cycle set in immediately, and talk about at least TRY 24 billion in additional expenditures that would burden the budget has reversed everything. Add to this sticky inflation that seems set to stabilize for a while only in the low double-digits when the dust settles, the poor communication performance of economic authorities regarding the new incentives package, and voilà!
Now many international finance houses expect at least a 200 basis points rate hike and a simplification of the interest rate policy before June 7. The second issue has always been on the agenda, albeit subjacently, and is a rational demand because the late liquidity window isn’t the most appropriate way to implement monetary policy. A policy rate that is liable to change overnight isn’t a stable anchor. Markets are tricky things at times. Nobody will await the regular MPC meeting on June 7, and the stability of the lira seems elusive in the absence of a rapid policy rate reaction. The odds are that absent any swift action by the CBRT, the TRY might depreciate further. S&P’s rating cut may have had an impact on all this also, but even without it overseas investors would have sensed the coming of the storm. Hence, I had uttered some three weeks ago that snap elections could be a good thing because the electoral cycle would be short. In theory, yes, but who could imagine the sudden announcement of a quite large package that would directly target the median voter – or at least the ‘undecided’ part of the swing (but right-wing nonetheless) voters?
Now what international investors demand can be encapsulated in a nutshell: raise the policy rate, simplify the monetary policy channel, stop ‘overheating’, don’t let politics get ahead of fundamental economic concerns. The problem has many symptoms. Overheated though the economy may be in 2017, it will slow down by itself in 2018 and beyond as leading indicators have already begun to signal. Otherwise, overheating will be a genuine concern because external balances are deteriorating and fiscal imbalances are accumulating simultaneously. Inflation is obviously high also. Hence, Turkey’s MSCI premium, which was 5.8 percent positive back in May 2013, is a negative discount of 47.5 percent. At that time, Bernanke had just talked about ending asset purchases and the taper tantrum was about to begin. The last 5 years proved indeed that by almost all indicators the Turkish economy was on a declining slope, except growth. Furthermore, Turkey’s rating was elevated to investment category by mid-May 2013. Non-residents current negative reaction to both the data and the news flows, including official announcements, shows itself in the net transactions. The selling off in the secondary market of 10-year government bonds isn’t a good omen.
The IMF has disclosed the Article IV Consultation Report and points to structural-cum-conjunctural weaknesses. There is a clear emphasis on overheating – mostly in 2017, on excess supply in the construction sector and the property development markets, and on financial fragility. The flow of funds is now extremely sensitive to overseas investors’ sentiments. Accordingly, the damage is done because the economy was overheated last year via a domestic consumption boom engineered by loose fiscal and monetary policies. As a result, both inflation and the current account soared. There is also a typical strategic policy sea change proposal. Front-loaded monetary tightness and contractionary fiscal policy are recommended. Otherwise, the growth momentum will be lost anyway because financial fragilities will constrain growth. The important thing is to pass to a controlled soft landing, so to speak, and not a disorderly one. The annual external financing needs will reach $229 billion in 2018 and $270 billion in 2019, which is purported to equal 27 percent of GDP. The net international investment position has again deteriorated – it is an overall concept and includes valuation effects of net Turkish overseas assets plus debt service plus current account financing - to 53.4 percent of GDP. Now, a similar warning had been issued by the IMF in December 2012, pointing to overheating and the net international investment position was 48.9 percent at that time. Again, the IMF had proclaimed that net external financing needs would reach $317 billion by the end of 2017. Obviously, the delay of the Fed’s expected monetary policy reversal, a long period of very low – even negative - interest rates, and the drop in oil prices have prevented this from happening. But now things are different. The current account deficit, despite the positive
expectations in tourism revenues, may reach 6 percent of GDP because oil prices have been trending up. Now that Iran is under the spotlight after Mr. Trump’s declaration, oil prices are expected to settle between $80 to $85 a barrel during the summer. That will add to both the deficit and inflation.
These are all well-known problems and there is no novelty in them. However, there are other supplementary factors that render the IMF outlook more realistic than before. Net CBRT reserves, for instance, are much lower compared to December 2012: $29.2 billion now as opposed to $53.7 billion then. The net reserves to shortterm liabilities ratio is down to 82 percent. The rest is again wellknown because the IMF always uses stylized facts to ring the bell. The ratios IMF uses to issue warnings are typical, and admittedly they don’t look good in the current case. One such typical observation is that the real sector is heavily indebted in hard currencies, the overall foreign debt-to-GDP ratio is climbing, and all the more relevant in the shortrun, FDI inflows are less than 1 percent of GDP. The Turkish economy is bank-financed so the non-core liabilities matter against a backdrop of not-so-fast rising – and dollarizing - local deposits; hence the credit supply capacity is also constrained. The main take is – and there is already talk about that - the IMF seems to think time has come for a new stand-by. This is what the ‘unpleasant arithmetic’ conveys: after Argentina, Turkey will be next. Some of the ‘stylized facts’ or typical crisis indicators the IMF ordinarily makes use of were always problematic, but the novelty here lies in the speed with which they are diving into the grey zone.
Is that so? Will there be a standby in 2019? Well, let’s see. It depends on the speed of adjustment after the elections. If attempts at growing at around 6 percent on top of the 7.4 percent of 2017 will be the flavor, then all sorts of imbalanc- es will indeed follow. In that case, the “Fed policy sensitivity” of the lira purported by two Fed researchers will continue, and so will inflation blues. Matteo Iacoviello and Gaston Navarro have improved upon their September 2017 presentation and came up with a paper on April 23. There are two fundamental conjectures here. First, a monetary policy-induced U.S. interest rate hike of 100 basis points will cut off 0.8 percent of GDP growth in emerging countries, a figure that is on par with the impact on American growth, i.e. 0.7 percent after three and two years respectively. It will also take a toll on other advanced economies’ growth, i.e. 0.5 percent, after three years. The second idea, however, is more relevant for Turkey because it claims the impact multiplier will not work through the trade and exchange rate channels, but mainly through a ‘vulnerability’ index that includes inflation, current account, external debt and reserves. It is this financial channel that is more interesting than the above mentioned classical channels because U.S. interest rate increases spill over to various emerging market financial assets and debt prices, assets and liabilities held abroad. If domestic actors are credit-constrained and hold sizeable amounts of FX-denominated debt, the impact will spread to their domestic balance sheets in the presence of flexible exchange rates. Admittedly, Turkey doesn’t score well by the vulnerability index in question. Indeed, the Argentinian peso and the Turkish lira were hit over the last year as the Federal Funds target rate went up. However, there is caveat here: the Argentinian peso tracks the FFR target more closely whereas the lira began depreciating before. There are factors that go beyond the Fed path.
Now the tricky thing lies in the question: ‘wherein lies the future in the construction and real estate development?’ Is there a possibility that authorities will begin working on bending the economy back to a potential growth path and simultaneously assure overseas investors that they won’t allow flagrantly obvious imbalances going forward? That should involve a simplification of monetary policy, a firmly anchored ‘equilibrium interest rate’ that guarantees at least 4 percent real rate so it can be perceived as equilibrium, a return to normalcy in the public finances and so on. This can be done in our opinion. However, there is a more problematic issue here. Because real estate is the locus classicus of modern financial crises, and because the construction sector is the primary locus of capital formation in this country, what should be done with excess house supply that emanates from Istanbul and Ankara, but now threatens the whole picture? The two graphics are intended to illustrate the situation relative to the U.S. housing market. The Case-Shiller house price index has been tracking a continual upward ward path since 2011, when the worst was over. In terms of monthly price changes, the CaseShiller has been steady for the last 4 years whereas the Turkish composite has been falling since 2015. The problem is Turkish inflation is far too high, and any nominal price increase below inflation means negative real return. All American nominal returns are also almost real returns because inflation was very low during all these years. Here, it is literally impossible to revive the housing market significantly unless expected returns surpass inflation expectations because the benchmark government bond offers over 4 percent real return in the secondary market already and TRY deposit rates are between 14.43 percent and 12.62 percent according to maturity, posting positive real rates. The CBRT house price Turkey-composite index showcases 10.09 percent. Istanbul is much lower. This is indeed a dilemma-like situation. Now either there will be an IMF stand-by or there won’t be. However, in either case interest rates will remain high for an extended period. How long can the mortgage rate campaign last under these conditions and what will be its effect on bank balance sheets? Tough question indeed.