Towards a structural adjustment programme?
It is – also - volatility now. No, it wasn’t volatility that was the root cause. Volatility rose steeply after the lira had already become anchorless. A good part of it was (is) a bubble though, or so I (still) think. Any serious CBRT intervention – had it occurred in the beginning of May - could have immediately burst the bubble component of the depreciation. ‘The rest is history’, so to speak. The fundamentals-related currency depreciation is a different matter; it is a historic phenomenon, and is here to stay. Not the bubble. However, in similar situations we have seen time and again that no Johnny-come-lately has ever solved any problem, even in the short-run, and if he did he managed to do it only at a very high cost. Delaying the inevitable isn’t a rational policy option. We have seen this before, like in January 2014. After having depleted around $10 billion of precious reserves, the CBRT had to raise the ‘policy rate’ by 650 bps – and the effective funding rate by 300 bps - at that time. Hence, bygones are bygones. Two weeks ago, maybe a 200 bps hike would have washed it, but not now. Again, a bubble isn’t – except as a theoretical curiosum perhaps - generally based on fundamentals by definition but this doesn’t mean it is less real. There have been ‘bubbles’ that lasted for many years in economic history. There can also be a bubble inside a bubble. Better not allow one to form in the first place.
What is to be done? Now, the CBRT is trying to catch up and is doing the right things. On a more general level, what is to be done is clear and obvious if you stick to financial account liberalization (Monetary Trilemma takes over from there and you can only try to control either the interest rate or the exchange rate – but not both) and to international financial integration (Financial Trilemma takes over from there and you can only either command the macroprudential macroeconomic policy set without any international influence or choose not to do it that way and keep financial stabilization intact – but not both). Given financial openness and international financial integration, you have to act in tandem with the international financial community, adjust your macroeconomics accordingly and raise the interest rate if need be. It is that simple. Even if you concur with Hélène Rey’s (London Business School) predicament to the effect that the (Monetary) Trilemma is in fact a dilemma because international monetary policy spill-overs – from the Fed in the first instance - constrain small open economies’ monetary policy choices, it actually strengthens the argument. In that case, there isn’t even a trilemma, just a necessity once you are open to financial flows.
In fact, ‘raising the interest rate’ is only a manner of speaking here because the interest rate is clearly endogenous now that the secondary market benchmark rate has hit 17 percent and the 10-year TRY bond rate 15 percent. The inversion of the curve is only to be expected and we might see that 10-year yield drop down a bit and equilibrate over 14 percent.
Even so, what is there to raise? It has already skyrocketed. You simply accommodate the current situation and give a signal that you have understood it. It is not a policy choice because the policy rate is not even weakly exogenous. If you delay nothing will change because markets will perform the adjustment nonetheless, and you will only come to terms with reality at a higher cost. Hence, it is more likely than not that there will be another hike. It is with the help of both the hike, supplementary measures and market-friendly talk that the lira has been calmer.
Now we await the second visit to London. After the last rate hike, we had to await Asian markets and London’s reaction. It is now clear that this move didn’t wash. Because it revealed a split among government members about how to conduct economic policies and because the move came late in the hour – maybe it isn’t too little but it is too late there is now the expectation that the CBRT raises the policy rate by yet another 150-200 basis points on June 7 during the regular MPC meeting. Even this may not suffice because it should possibly be accompanied by a clear statement to the effect that the CBRT is independent and will continue to act accordingly, which is being done by the way. However, confidence and credibility are fragile things. A simplification of monetary policy, i.e. abandoning the ‘adjustable overnight’ late liquidity window as the main channel – it makes no sense now if it ever made sense then - may also be warranted. That much is obvious.
Yet, this is not the gist of the story. Turkey is heading towards a structural adjustment programme that will either be conducted under the auspices of the IMF or a homemade IMF-equivalent programme will have to be announced, possibly before 2019. I don’t attach much weight to an IMF standby but I also know that a self-implemented IMF-equivalent programme is very unlikely to be either credible or capable of going on to the end uninterrupted – these two considerations are interrelated of course. ‘The genie is out of the bottle’ so to speak. We must see the election results and the reaction of Western financial centers to its aftermath. Nevertheless, the Turkish economy has been drifting anchorless for over a decade now and this is what probably has – at long last - come to an end. Turkey needs a clearly designed economic stabilization programme that is reminiscent of the one adopted in 2001 under Kemal Derviş. This, and this alone, can solve the puzzle. Raising rates with a ‘muddling through’ perspective – always staying behind the curve - is no panacea for either solving the structural problems that have never been addressed or rendering the economy attractive to FDI and portfolio inflows anew. As part and parcel of the new approach, the CBRT should stay ‘ahead of the curve’.
What else? Now that Pandora’s Box is open, what not? A return to orthodox central banking practices (single policy rate, a statement from the highly placed authorities to the effect that Central Bank is indeed independent, measures concerning required reserves that would inject FX liquidity etc.) and a front-loaded interest rate hike – meaning the CBRT is no longer ‘behind the curve’ - can help at this stage. However, this is only the standard argument. Because growth is dependent on capital inflows of all sorts and on loan growth –net exports ‘contributing’ negatively - there will be a two-tiered impact. High deposit and loan rates will thus be accommodated, and this will curtail consumption in turn. Growth will slide back to 3.5-4 percent as the IMF predicted in March 2018. This will be 1.51 percent below potential, so the output gap will widen and should help check inflation. Nevertheless, if confidence is restored overseas investors can find a good entry point at the current level of the exchange rate, which is oversold in my opinion. Then, because the housing sector is in trouble, there should be other measures to be implemented. Construction and real estate lie at the heart of the fixed capital formation here. Engineered mortgage rate cuts implemented by public banks was (is) one such measure but it won’t last long and can’t solve the malaise in that sector.
So, there are two distinct but intertwined problems: the exchange rate and financial stability is one, housing recession and the heavy unhedged FX debt burden of some real sector firms is another. Basically, the economy is out of steam and in the absence of public expenditures, tax reliefs, incentives of all sorts etc., it is destined to cool off by itself. Organizing the retreat is all that matters. Targeting above potential growth for 2018 – and definitely for 2019 - at all costs is no longer a viable option.
After the elections, irrespective of whoever is in charge, there will have to be a stabilization or, better still, a structural adjustment programme. It can be delayed of course until 2019. Import prices are a problem for instance and there are many things that can be done to change the composition of imported inputs in order to curtail the import bill. It is impossible to conjecture that the government doesn’t know the structural problems. It is possible to assemble human resources to come up with a plan, but the gist of the matter lies in implementation. Delays are possibly due to the wave of unending elections. Therefore, it isn’t merely a monetary-cum-fiscal tightening in the old fashion that will do the trick. A consistent programme is required. To begin with, inflation has to be anchored in single digits again. Actually, the days when the TRY was ‘overappreciated’ are long gone. That was before Lehman. If you look at the real effective exchange rate vis-à-vis trading partners you will see that it is at the lowest if we take the span of a decade.
If a weak lira helps boost exports, it is already helping. This is why I emphasized the import structure. The other side of the coin lies in the debt and balance sheet structure of the corporates. It directly hits firms because they are FX-indebted and they carry a sizeable short position. Yes, a weak lira discourages imports but this also means lower growth. Furthermore, the conjuncture isn’t favourable. Oil (Brent) prices seem set to stabilize between $80-85 a barrel. Most of the current account deficit comes from the energy import bill plus gold imports and however wise can the remedies be, substituting imports can’t occur overnight. Inflation is also a concern. It is heading towards low double-digits as a stationary state, and that is problematic because whatever one does no overseas investor will see an expected real rate of interest less than 4 percent as (a temporary) equilibrium. Currently, the ex ante real interest rate stands over 6 percent as measured by the difference between the CBRT inflation expectations survey and the secondary market benchmark government bond yield. This is far too high. A comprehensive structural adjustment drive, if successful, will eventually lower the real rate of interest.