Auto-stabilization or a designed soft landing?
Hélène Rey (London Business School) has suggested that the Trilemma is in fact a Dilemma. The Fed’s monetary policy spillovers have a bearing on EM monetary policies or not according to how open or not they are to financial flows, in proportion to the degree of their openness. This is even stronger an argument than the Mundell-Fleming Trilemma. A small open economy – this is a technical term; the economy is not necessarily small, it just can’t change world prices and takes them as a given - with a heavy FX debt and a large current account deficit is liable to bear the impact of Fed policy change spillovers. The only way it can benefit from the adverse general impact – the size of cross border capital flows to EMs will be smaller due to both the Fed interest rate hikes and the downsizing of the Fed balance sheet - is a flawless record of internationally cooperative monetary policy, central bank independence, rule of law, sound ‘doing business’ conditions and suchlike. The share a specific country attracts from a shrinking pie can actually increase thus. However, we are nowhere near to completing the good deeds list!
First, consider the obvious constraints. Turkish GDP, although it is a ‘small open economy’, is very much like the American GDP. Domestic consumption is key and accounts for 70-73 percent of the lot. Investments depend on domestic consumption’s strength. Savings aren’t high enough and the energy import bill is hefty. Hence, there is always a current account deficit. Exports, even if they rise, don’t contribute much to growth because imports ordinarily increase even faster. International prices don’t help either: the terms of trade are currently unfavourable. The real effective exchange rate helps boost exports to the extent it can because it is at its lowest over the span of more than a decade.
Nevertheless, then there are the following issues: in order to export, an inordinately large amount of intermediate and capital goods have to be imported first and the corporate sector is heavily FX indebted, with a $213 billion short position. Also, most sectors aren’t even near the technological frontier, and this shows up when you look at the approximately 2 percent share of high-tech exports in total manufacturing exports. Then, there is inflation which is fueled by the exchange rate and import prices pass-through. Further additions will surely come from oil prices. Unless demand is curtailed a 14-15 percent CPI peak is in the cards. A sticky low double-digit inflation may already be a foregone conclusion for 2018 – as it was in 2017.
Since growth – and to a large extent unemployment, which isn’t adequately measured by the way - is dependent on credit and since the supply of credit depends on external financing to a large extent – and its cost - it all boils down to one big financial constraint. Without incentives and subsidies – and public expenditures - and without loan growth, the economy can’t grow at its potential. If you ‘overkill’ and provide too much stimuli ahead of elections, referenda or whatever, and this seems always the case, the economy grows above its potential – as it did in 2017 - but then sooner or later there will be a cost. Equilibrium is quickly lost in the absence of cheap and abundant capital inflows and the need to rebalance raises its head – as it does now.
There are three structural problems that may also have a shortterm negative impact. Primo, the construction and real estate sectors have become the prime mover of capital accumulation over the last decade. Taking into account linkages with other sectors, construction accounts for almost a quarter of the economy. Now not only home sales fall, but also house prices dive down in at least two major cities, bearing negatively on the composite index. In fact, recently prices have been falling steadily, and that is worrisome given excess supply – at least 2 million flats. Construction permits have fallen by 23.5 percent. White goods sales posted a 20 percent decrease in the first four months, a housing sector-related metric. Industrial production looks vibrant in Q1 2018, although on a monthly basis it has begun to lose steam. However, the quarterly performance also may not be as good as it appears to be. Automotive production, for instance, didn’t change much in quantity terms. There is a change of composition in exported vehicles and input costs have increased, which were translated to export prices. Hence, in price terms there is an increase but the actual output didn’t change much.
Actually, sectoral and consumer confidence indices, housing and white goods and some others sectors, and the rampant demand for longstanding huge FX debts of large companies, all suggest the beginning of a marked slowdown. Electricity production has decoupled from industrial production, for instance. Electricity production rose by 3 percent in Q1 2018 whereas the industrial production increase has more than tripled that. This much discrepancy is a bit annoying, suggesting a price effect in production figures. This is also borne out by the capacity utilization rate.
Secondo, large debt restructurings blur both the corporate and, more importantly, the banking outlook. True, demands for refinancing and debt restructuring didn’t shockingly come out of the blue; some problems were known to the public even years ago. Nonetheless, the sum total of restructuring demands of 8 large conglomerates add up to $20 billion. Clearly, the banking sector is well capitalized and profitable – cost increases at the margin can be passed on to the consumer as long as loan demand is rather inelastic. Even so, there is a limit to everything and the large debt restructurings, coupled with the general understanding that NPLs are so low because they could be sold and so on – they may rise - explain the poor performance of the banking sector in the stock market, if anything explains it. Indeed, at 16.5 percent CAR (capital adequacy ratio) and at around 15 percent expected 2018 ROAE (return on average equity) how do we explain the 0.55x P/B (price-tobook) multiple Turkish banks are being traded with? For an economy heavily dependent on banking because capital markets are shallow, the lending ability of the sector is of prime importance going forward. Non-bank corporate FX debt was about $43 billion in 2002. It is about $160 billion now. The private sector’s FX stood at 18.2 percent of GDP then; it is at 37.2 percent now despite the fact that GDP in dollar terms GDP rose from $238 billion in 2002 to $863 billion in 2017. Domestic corporate credits were only $30 billion back then, and now they stand at over $400 billion. As refinancing and restructuring go, numbers are huge compared to the past, and ratios have also gone up relative to GDP. Credit is good, but it sometimes gets out of hand and it all depends on what you do (did) with it.
Terzo, the cost of capital increased steeply over the last years and there are no new capacity investments today. Go back 5 years and the benchmark bond rate was at 7 percent as opposed to 17.7 percent. This isn’t the only reason why debt ratios skyrocketed and profitability ratios fell. Excessive reliance on construction began to squeeze profit rates and the channeling of funds and credits to this sector in order to render it workable anew caused a further stir as the cost of capital rose. In a Cobb-Douglas type production function world, and it is clear that capital contributes more to potential growth than labor – more so in the new GDP series that reflect the role of construction in depreciable fixed capital formation - encountering diminishing returns uphill is only normal. Back in 1994 and in 2001, there were capacity increases before the crises – in automotive and textiles before 1994 and in 2001 again in the automotive sector - and the economy could rebound using existing capacity in the aftermath. Energy has also been overcrowded, so to speak. True, manufacturing is a bit more colorful and the residual TFP (total factor productivity) is bound to be higher as growth rates were revised upwards in the new series, but this is also of the ‘too little too late’ kind. Government has been stepping in all too often in the last 5 years and tax reliefs, untargeted incentives, the credit guarantee fund, public expenditures all helped turn the wheel. This has ‘overburdened’ competition and ‘overdetermined’ the market equilibrium because the creative role of competition has been minimized as a result of such generous assistance that prolongs the life of uncompetitive firms. Now that exports don’t promise more than what is extant, and that domestic demand is about to slow down, if not deliberately curtailed outright at some point, there is no rationale to engage in capacity enhancement either. That will bear on what we call ‘potential output’. Here is a glimpse.
A CBRT study using a multivariate filter approach that attempts to measure both the output gap and the potential growth rate with both the old and the new series gives us an idea of what has happened. Potential growth is higher – obviously - in the new GDP series. Single-filter techniques render it at around 5 percent whereas the reported multi-filter approach has it at around 4.7 percent. In this case, the 2017 output gap is a lot more buoyant and adds to output gap volatility. Let’s put it this way: if the results of a direct approach –again a CBRT study WP 2018-04 - are valid, an output gap that is positive by 2.5 percentage points is conducive to many side effects. It creates such an environment that cost increases are passed on to the consumer, and it paves the way for interest rate hikes that pull the economy towards the potential growth rate. However, the slack we can cut through the new series is more open to fluctuations as the role real estate and construction play in capital formation fall. The potential itself could fall further, and it definitely will if we use any filtering technique, multi- or single-, regardless. Retreat by design is better than leaving the job to the price mechanism, a mechanism that has never functioned by the way in a fully efficient way.