Central banks: easing and beyond
Rate cuts lie ahead. Because the Fed is about to ease further, or so most market players think, and because Turkish inflation will fall to slightly above 10 percent on October 3, the CBRT’s rate cut has passed with tacit approval. Further cuts are in the making. Another 425 basis points would entail 1-1.5 percent ex ante real TRY interest rate though, which is a bit problematic. Let’s see if the strength of the lira can endure in H2. There are two possibilities given the purported interest rate cuts: either it will be short-lived, until late September say, or it will persist.
Real interest rates and financial stability
A widely-acclaimed conjecture in developmental macroeconomics maintains that a central bank-driven rise in the real rate of interest will lead to a real currency appreciation and will make government debt attractive. We have indeed seen many instances in Turkey whereby this conjecture proved true. But we have also witnessed that, if real interest rates increase the probability of default, government debt may become less attractive – at the going rates of interest - and currency depreciation may ensue. The latter outcome is more likely the higher the initial debt stock, the higher the proportion of FX-denominated debt and the higher the price of risk. If an interest rate spike raises the probability of default, inflation targeting under the float and via a Taylor rule is not immune to a perverse effect. Even an interest rate increase in response to higher inflation may then lead to a real depreciation. Assuming structural change is incomplete, and therefore the passthrough is still high, a real depreciation implies higher inflation. The situation is symmetric. Just as interest rate decreases in response to lower inflation leads to real currency appreciation, rate hikes may imply real depreciation. We may call it a “vicious cycle”, generated by a perverse monetary policy effect. It is fiscal policy that makes all the difference, and in such a case, it may be advisable not to change the policy interest rate, but increase the primary surplus by cutting government expenditures more. It is fiscal policy, not monetary policy, which should become the main defense line under this outcome. And it is true that this line of defense worked in Turkey; government debt stock is low and the proportion of FX-denominated government debt is also low, or at least it was quite low until recently. However, private sector’s FX-denominated debt is higher than ever. So, does all this mean the government has a go all the way down the road, spending a lot to shore up growth without any eyebrows rising in the financial markets? This is what it does currently, yes, supported by the Fed’s new course and by falling inflation if only due to base effects. Well, the answer is both yes and no.
First, the CBRT under the new management isn’t swimming against the current; it is acting rationally. Effectively speaking, tight monetary policy has been the norm since mid-January 2018. After the late liquidity window rate increase, the CBRT provided TRY 5 million through BIST, a move that resulted in an average funding rate of 11.74 percent at that time. Delays or not, bearing an impact on carry trades mostly or not, CBRT funding went all the way up to 24 percent. Now this was tight, but using other means to fuel loan supply and reduce the cost of government debt, often at the expense of precious FX reserves, blurred the picture. Is it then possible to claim that monetary policy was severely constrained by politics over the last few months? Yes, but still it was admittedly a clear tightening. Politics intervening or not intervening, money will never be as cheap as before. Loan rates may fall a bit, as public banks’ mortgage campaigns demonstrate. Will it suffice to help big real estate business? Not unless home prices rise. In many locations, home sales attract foreigners mostly.
If the risk aversion coefficient of foreign investors is higher than the average risk aversion, then an increase in risk leads both to capital outflows and to a rise in the stated rate of interest on government debt, via the arbitrage equation. It is possible to show – at the risk of filling these lines with more notation and commanding more space - that along with an increasing probability of default, rising interest rates would go in tandem with currency depreciation. This argument is in line with academic research and many works published by the IMF to the effect that it is possible to defend the currency, both under a peg and under the float, up to a certain threshold beyond which the relationship is reversed. The degree of fiscal dominance over monetary policy determines the
threshold. We are talking about regime-switching here, whereby the relationship between the exchange rate and the interest rate becomes non-linear. This is what may already have happened since April. And it doesn’t have to be fiscal dominance as such that causes regime-switching, any equivalent risk factor could do that.
This is the best explanation I can come up with to render the government’s economic discourse intelligible. So, what is the relevance of this olden day tale? Do we have a fiscal problem yet? No, not in the sense that there is fiscal dominance over monetary policy; but the fiscal stance has been weakening over the last two years. Yet any risk factor that may be deemed equivalent to fiscal dominance would have the same effect. Interestingly, the Fed is so dominant that even the S-400cum-F35 business and problems in Syria didn’t pass for genuine risk.
Monetary easing requires fiscal tightening
On the other hand, fiscal policy has been very expansionary indeed. It is not only the local election effect, but rather the result of a chain of elections and other incidents that have been following each other since 2013. True, monetary policy has been loosened whenever it was found opportune to do so, and the long-view M2 graph gives us clues as to its timing. Nevertheless, budgetary expenditures and the credit channel through public banks were the main stimulants for economic activity at home. Clearly, the government has never judged it appropriate to launch into a well-prepared and comprehensive attack in order to remedy the structural weaknesses of – at least - the manufacturing industry over almost a decade now. Rather, it has resorted to fiscal stimuli or stimuli of the sort we have observed through the credit guarantee fund in 2017. Is this state of affairs a contradiction? To some extent no, but only to some extent. Let us inquire into this a bit.
In our view, barring any currency shock, and if there is no natural disaster that would jump food prices all of a sudden, CPI may fall to 11-11.5 percent in December. The emphasis is on “may”. Then again, it may not, due to a renewed exchange rate shock or to hikes in administrative prices, gas, electricity, tobacco etc. There is even the possibility that it will slide below 10 percent in early 2020, after which point everything will depend on pricing behavior. What is a lot more important is the behavior of prices after that point, i.e. what will happen after favorable base effects vanish? Not only can fiscal restraint be very effective in keeping pricing behavior under control, but also it may be the sufficient condition. Not fiscal austerity, not a fiscal rule, but fiscal restraint could suffice in 2020. If pricing goes on along normal lines, that is if double-digit inflation is not built into prices as trend, then it may indeed fall to slightly below 10 percent trend-wise. It is not exactly obvious whether what we perceive as the new trend and the head-on future inflation paths will coincide in 2020. There are still several big “ifs”. However, if the CBRT attributes due weight to inflation, and keeps its wording intact, and doesn’t overkill in easing, that might happen. That is, until it sees trend inflation heading south, it should stay put at some point.
Loans and interest rates
The latest data shows total loans grew by 1.84 percent annually – 13-weeks MA FX-adjusted - while public banks’ lending stands at 4.8 percent. Private banks’ loan growth is still negative (-1.4 percent) according to FX-adjusted 13-weeks moving average, annualized. By the same metric, public banks began the year with negative growth, which subsequently went up to 47.6 percent in April whereas private banks were lending at a pace of 6.6 percent in the same month. Consumer loans and credit cards now grow by 0.05 percent annually whereas they started the year with minus 0.12 percent. That is, there is no growth. This is clearly a function of the fact that credit growth moved very closely with local deposit growth last year. In other words, overseas funding didn’t make a positive contribution. In the past the situation was entirely different. In the new market environment, either deposits will be attracted via high deposit rates, in which case the lending rate will be even higher, or loan growth will remain subdued – or so we thought. However, currently deposits grow at a much higher rate than loans. So, even this conjecture entailing a conservative loan growth estimate was belied by events. It is both about recession - earnings don’t grow - and high interest rates triggered by the two currency shocks of 2018. Since public sector deposits in accounts with the CBRT are also low, both in FX and TRY components, it is hard to imagine a liquidity stemming injection from that.
In the aftermath of the elections the lira has positively decoupled from EM currencies and appreciated. Before that, there were issues related to confidence and also international factors such as the rising Dollar Index, CDS and swap costs, expatriation of some cross-border funds, etc. The FX debt of local firms also played a role. All in all, the depreciation was rather steep, and I didn’t think anywhere less than 6.10 USDTRY by December 2019 was in the cards. Now, nothing has changed in fact. The only thing that has changed is risk appetite, and Fed is the almost sole driver therein. There is a kind of credit opened by international markets after the elections and market players hope that the composition of the new cabinet will appease their worries. The structural problems remain of course, but there is now a distinct possibility that the worst is over. Notwithstanding high shortrun hopes, what is to be done will have to be done.