Banks and economic activity

There is the following claim. The ‘muddling through’ scenario I have toyed with several times is rather optimistic because it relies unduly on an automatic business cycle mechanism. Accordingly, even if the Fed comes to a full stop unless capital inflows flourish anew a genuine recovery might not obtain all that easily. True, beginning in Q3 2019 there may be some improvements with the background of base effects, falling inflation due to lack of effective domestic demand, oil prices and suchlike, but this wouldn’t amount to a genuine comeback in economic activity. The first argument would involve loans because unless real loans grow there is no real GDP growth. This we may pose as a ‘stylized fact’. Second, it is predicated upon the assumption that there won’t be another exchange rate shock throughout 2019. Third, even so it is a flawed argument because, as some AKP followers claim, it posits that the aggregate supply curve can be rendered elastic very rapidly – or it is already so. Of course, foreign financing constraint shouldn’t bind either although we know that it binds. In toto, it portrays a rosy picture where the odds aren’t so bright.

Weak cred t growth ahead

I concede the banking and real sector part of the argument - no loans, no growth, that is. Even if there is growth, it won’t be domestic-demand driven. So, this part of the argument is probably correct. In fact, we are in the middle of a credit crunch. Weekly data as of December 21 reveals that FX-adjusted loan growth fell to 3.5 percent year-on-year, down from 8 percent two months ago. As of December 21, 13-week MA annualized TRY commercial credit is at minus 15.5 percent. By the same metric, consumer lending displays a negative 14.9 percent yearly growth rate, further down from minus 7 percent two months ago. These are clear signs of an ongoing recession. Total deposits seem to go up or down on a weekly basis according as the exchange rate goes up or down. Anyway, TL deposits are still on the fall. Inflation-adjusted total deposit growth stands at minus 2.42 percent yearon-year in October and that is telling. With such meagre deposit growth, banks can’t lend much because overseas costs climb and are set to head north (a bit) further in 2019. NPLs look deceptively low at 3.91 percent, now up from 3.34 percent two months ago, but everyone knows this is not the way to look at problematic loans. More importantly, systems’ NPL coverage is about 10 percentage points lower than the pre-Lehman episode. NPL coverage may fall still, but obviously if the Group 2 loans go up and further restructuring will be needed, there will be higher loan loss provisions eventually. They are around the corner, so to speak. No wonder, loan growth rates – that is contraction rates for private banks - hint not at a slowdown, but at a credit crunch. We also at least can guess that the effective NPL ratio is higher and is bound to climb the hill in the snowy winter of Q1 2019. So?

Why are interest rates falling then? There are obvious reasons related to policy, but there is also another way of looking at it. As the intensity of competition increases, the average loan interest rate (resp. the average deposit interest rate) becomes less sensitive (resp. more sensitive) to changes in the CBRT policy rate. Furthermore, in the double Bertrand competition case, competition takes place only in the deposit market and in the first stage of the game. Then, whoever wins the deposit collection game wins the loan supply game also, assuming of course that there does not exist an infinitely elastic funding source such as the money market that could replace deposits as a source of funding. This bit of theory may help explain past episodes of rather fierce competition over deposits, just as it might help understand why there isn’t now and there won’t be no deposit collection tournament going forward. Because banks won’t lend, they won’t compete to collect deposits. Therefore, deposit rates are bound to fall – within certain limits of course. This doesn’t automatically imply that credit interest rates will also fall though. Screening through deleveraging may sometimes help keep the NIM intact. Accordingly, both the TRY and the FX deposit rates have already fallen over the last week. I expect this fall to reach 100 percentage points shortly, and then it could even become more significant. Why incur high funding costs if you can’t do much with the funding ?

The deposit rates’ inflexion point would theoretically be set at the inflation break-even. Unless inflation expectations fall shortly, lower TRY deposit rates would mean after the inflation breakeven threshold that TRY deposits won’t even protect against inflation, i.e. the real interest rate will turn to negative. Turning to FX is one option. I don’t think real assets will become attractive soon enough to enter the game because the drop in the TRY depos-

it rate isn’t large enough to render them appealing any time soon. The first and foremost implication will possibly be a credit crunch.

The problem is deeper than it may appear to be. Domestic credit supplied by banks as percentage of GDP shows Turkey is at the middle of the road. True, the credit stockto-GDP ratio is much higher in advanced economies than in EMs, but still Turkey ranks as average amongst EMs also. A more important finding is that deposit money bank loans rose from 10.7 in 2003 to 57 in 2017 as percentage of GDP. Consumer loans and credit cards went up from 2.7 of GDP in 2003 –virtually non-existent- to 15.1 of GDP in 2017. The trend has been up in a rather steep vein because GDP has also risen significantly during that period. Although the ratio of the outstanding credit stock to GDP is about average in a rather large panel of countries, peers and non-peers alike, the sheer speed made it so happen that further lending is now problematic. Because local financial markets in general are rather shallow, and because local deposit growth couldn’t match local credit growth, banks have already come to a halt at a less than 60 percent GDP outstanding credit stock. This is a very significant finding because it implies there is a limit to credit growth. Unless non-core liabilities rise in tandem, and at a low cost at that, Turkish banks have no choice but to curtail their lending in 2019 also.

But this isn’t the end of the story

So, we need a comeback in lending if growth is to recover possibly in Q3 2019 at the earliest. The other constraint, the foreign financing constraint, is also effectively binding. It is believed to be a ‘soft constraint’, so-to-speak, because one way or another funding was secured in yesteryears. It needs not be always so. First, consider the obvious constraints. Turkish GDP, although it is a small open economy, is very much like the Ameri- can 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 unfavorable. 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. 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 $210 billion short position. Also, most sectors aren’t even near the technological frontier, and this shows up when you look at the two percent or so 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. 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 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, 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. Hence, the need for a renewed rebooting through the softening of the external financing constraint, which may be facilitated by an international agreement after the elections. It is still (silently) in the cards, I think.

Is supply elastic enough?

I think it still is. However, recovery shouldn’t delay. Otherwise, there will a prolonged stagnation after the recession, which is atypical, and productive capacity (physical depreciable capital) might become partly obsolete within a couple of years. 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. Clearly, the banking sector is well capitalized and still profitable – cost increases at the margin could be passed on to the consumer as long as loan demand is rather inelastic. However, we may have used up all the slack on that front. There is a limit to everything and the large debt restructurings, coupled with the general understanding that NPLs are much higher than reported, explain the situation. There is no significant demand for, and there is no significant supply of, loans now. Public banks can’t do it alone.

Can the international financing constraint be relaxed?

According to Thirlwall (1979), now a dated but still useful external financing constraint model, model, long-run (potential) growth rate is fixated by the exports growth rate and by the income elasticity of imports. Accordingly, the change in the exports growth rate matters. In fact, the income elasticity of imports and export growth are inversely related. Exports would contribute less to GDP as the income elasticity of imports rises. Now the income elasticity of imports should fall if domestic supply (capacity) heads north. We will have to put this in the coming years on two accounts: the income elasticity of imports will need to fall if exports are to contribute more to GDP growth and this can basically happen only if you curtail imports and produce them domestically. Do the converse, and when the time comes, you will see that even net exports won’t help much.