Cen­tral banks: eas­ing and be­yond

Dünya Executive - - ANALYSIS - Gunduz FINDIKCIOG­LU Chief Econ­o­mist

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.

Risk aver­sion

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.

Ex­change rate

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.

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