Exchange rate, volatility, and all that
We all know that financial stability is a must, not only for a mild recovery but also even for zero growth. Because we are in recession, zero growth would be an improvement. We also know that inflation will fall no matter what even if it will be dependent on base effects. If not for anything, in September there lies a huge base effect. September 2018 monthly head-on CPI was 6.3 percent. Even if there is a currency shock, it is very unlikely to beat that. In the ‘as is’ scenario, there lies about five percentage points fall in annual (12-month) unadjusted inflation. Hence, we may discount this, and come up with something like 14.5 percent come October. June, August and October also bring in favorable base effects. Even if unprocessed domestic food prices slow down the fall of the head-on CPI somewhat, still any Taylor Rule would signal room for a sequence of policy rate cuts. I pen in 400 to 600 basis points CBRT funding rate cut in H2 2019. This could cause inflation to move in the opposite direction but unless there is a marked recovery in domestic demand it is hard to imagine anything that surpasses 17 percent by the year end. The rather large band I had in mind was 13-17 percent. Nevertheless, we are more likely to see a steeper fall as the year end approaches, and the lower bound looks more realistic as time passes by. Having said that, is the financial stability we are talking about guaranteed? Is it temporary? What about foreign holdings of bonds and equities? Is volatility low enough? Will the Fed’s seemingly permanent sea-change and the standby attitude of the ECB suffice to generate enough risk appetite? Has the time come for global interest rate cuts? Are there any genuine global, or more to the point, regional political risks?
Last year’s currency shock set in in two episodes: May and August. It doesn’t hit as if there was a gradual depreciation. After Lehman, yes, the lira always depreciated above inflation except two years, but it kind of jumped and reached a new plateau all the time. Then it settled somewhere below the peak depreciation for a time. The lira is vulnerable for a number of reasons everybody knows, but the exact timing, the steepness and the magnitude of the upswing, often times bordering ‘overshooting’, has involved a surprise effect. All analysts assume relative stability for 2019, if only because the lira was already hit harder than it deserved last year and because implied volatility has come down drastically. Now, relative stability may mean the current level or it may mean 6-6.10 against the USD, but it doesn’t entail any depreciation that exceeds the inflation differential. As such, political tensions can act as catalysts, as we have seen in 2018. If this happens again, I don’t know what to say. Because a new shock will completely stifle the real economy, trigger potential inflation one more time, make sure interest rates track an upper course, and possibly cause balance sheet recessions there is no margin left therein. Even if it does stay put, a genuine recovery would require a lot of measures that aren’t clearly articulated yet.
Having said that, there is no - I repeat, no - fundamental reason the lira should depreciate beyond the normal inflation differential-covering parity. Yes, the mean (level) may go up from time to time but the volatility is very low. Compare the current GARCH USD/TRY volatility with August. It reads as 10.20 versus 70.64. It had come up from a 5.31 minimum in March 2018. I don’t see how this pattern can be repeated. It takes a lot of tail events. Otherwise, I’ll stick with the main scenario. Similarly, both the VIXEM and the TYVIX – it is U.S. T-note volatility and thus complements equity volatility VIX - are low. The homemade nature of the 2018 currency shock is testified by the fact that the VIX-EM and the TYVIX peaks don’t coincide with Turkish asset divorce with the EM risk indices. TYVIX peaked in May 2018 at 5.31 for instance. VIX-EM peaked by the end of March 2018.
Last week, TR 10-years have been sold and carry trade positions closed, so the USD/TRY ended up closing above its 200day weighted average. It is indicative of a changing risk perception. Turkish equities are another matter since value investors – not obviously growth investors - will be in I presume on account of cheap multiples. There are two different sources of money there and two different stochastic processes have been running their courses. Actually, foreign holdings of Turkish bonds have been diminishing since mid-2013. No matter what the ex ante real interest rate is, this situation can’t easily change. It has by now long-memory fed in.
Through the looking glass
However, just as the market risk isn’t the only risk the Turkish economy faces – it still faces a ‘composite risk’ so to speak: market, credit, political etc. - a rate hike isn’t a panacea for addressing structural problems. Similarly, the recent CBRT signal is good but standing still doesn’t solve all the problems. Because market risk is still ‘composite’ and because residents don’t yet believe in the stability of the lira, and because all of a sudden, an unmeasured political risk can emerge – as it did last week - the necessary condition (currency stability) isn’t a sufficient condition. From the corridor talks or pre-play negotiations, I understand that the financial engineering part of any conceivable solution to the corporate FX debt problem is again under scrutiny. This is good news. However, there are other, more persistent issue at stake also.
For one, the Turkish economy looks like the U.S. economy in terms of its GDP composition, a persistent current account deficit, its insufficient level of savings etc. – less technology and capital formation levels of course. Private consumption always hovers around 75 percent of GDP, the share of the public sector is about 15 percent, and gross fixed capital formation accounts for around 30 percent. If we look at it from a domestic demand/external demand dichotomy, domestic demand is almost everything from a net expenditure perspective, net external demand contributing negatively by 4.5 percent in 2017. Exports may go up from time to time, but so do imports because exports are dependent on imported inputs, and not only energy at that. Therefore, it is extremely difficult to engineer a switch, turn exports into an engine of growth and rebalance radically via this route. No, if one stifles domestic demand, growth turns into red. Hence, rebalancing ought to involve a rebalancing between domestic sources of growth, such as rendering fixed capital formation (investments) the main demand item, and curtail household consumption a bit. Or else public expenditures could be locked in a disciplinary box, and the weights of public/private sources of demand could be modified. If the economy is set to grow at about its potential rate, i.e. 4.5-5 percent, then domestic demand, although reset and altered in its composition, will have to endure nonetheless. Not only that: Investments can’t pick up, especially given the composition of the financial account. Turkey can only invest if, and only if, there are net capital inflows. No matter what the current account becomes – it has been shrinking all the way - it is the magnitude and the sustainability of the financial account that determines investments.
Composition of demand
From the production viewpoint there is a discrepancy. Construction accounts for 17.3 percent of GDP in terms of investments whereas machinery & equipment covers 10.5 percent. However, the share of construction in GDP from the production side is only 8.5 percent. True, there are forward and backward linkages and construction always has more weight in driving both growth and capital formation – and non-farm employment - but as the graphic depicts, it has risen to levels that suggest unbalanced growth at times. Over-reliance on construction and real estate development – and energy investments, obviously - has taken its toll because these sectors don’t contribute much to technological innovation and exports. Any rebalancing needs to involve a setback in construction investments relatively speaking and an increase in industrial investments. Even so the damage is done and the debt incurred by those sectors will have to be refinanced and restructured via some kind of debt-equity swap mechanism as I suggested last week. There is no coming back to the boom phase of the construction cycle any time soon and the growth model of the old days now looks like ‘a portrait of the business cycle as an old man’.
The role of credits and public expenditures
As we shall see when in a couple of days, the Q4 GDP data will be released – actually it will be released the same day this issue will be published - everything in terms of economic activity depends on debt, i.e. credit. Yes, it is the financial account but even then, it isn’t only the financial account that either covers the current account deficit or doesn’t cover and we resort to reserves and net errors & omissions, it is also domestic credit. Nevertheless, domestic credit is also dependent on non-core liabilities, i.e. funds borrowed from abroad by banks and any problem banks encounter in securing syndications will result in lower credit growth at home. Already, this is happening. With negative private bank lending – because domestic savings don’t suffice to fund significant loan growth - already negative if annualized from FX-adjusted 13-week moving average data, and with corporate lending coming to a halt also, a quick reversal of GDP growth rates can be expected, which many an investment house have factored in recently. Sustainable credit growth is a necessary condition for securing even trend/potential growth. As such, banking activity doesn’t support even 4.5 percent growth. There also a ‘rest point’ that should be found, a point after which – and after significant restructuring of already existing corporate debt incurred by banks - lending activity can pick up, albeit at a slower pace than before. Again, it isn’t the current account deficit alone that triggers the kind of slowdown we envisage currently. It is corporate FX debt mostly that remains the main culprit. So, we still await.