Recent currency gains and a reduced current account deficit appear to suggest that Turkey’s unorthodox policy mix is working. But analysts warn that the risks of a hard landing remain severe
For much of the past year, Turkey’s unorthodox monetary policy has puzzled investors and divided economists and analysts.
To recap, Turkey’s central bank surprised the market in late 2010 and early 2011 when it began to cut interest rates and raise banks’ reserve requirement ratios in a bid to combat inflation while also taming sharp capital inflows and curbing runaway credit growth. The country’s unorthodox policy mix has since evolved through several iterations, with the guiding principle being a reluctance to rely on the orthodox monetary policy tool of choice – interest rates – and instead to use a variety of policy instruments – most recently by adjusting overnight lending rates and one-week repo rates, coupled with currency intervention in the form of large-scale dollar auctions.
Some have derided it as a flawed policy that is likely to result in capital flight and a hard landing. Others have lauded its “postmodern” approach as a blueprint for how to set policy in an environment characterised by volatile capital flows, uncertain growth and prolonged ultra-low policy rates in Europe and the US.
By the end of last year, it seemed as if the naysayers were being proved correct: the Turkish lira fell 18% against the dollar in 2011, the largest decline among major global currencies according to Bloomberg data, inflation had ballooned to double-digits, while the country’s current-account deficit hit swelled to an all-time high amid predictions that the country’s 8%-plus GDP growth would likely come to a shuddering halt in 2012.
But, a month into the new year, things appear to be looking up for Central Bank of Turkey governor Erdem Basci. Following a number of significant dollar auctions designed to boost the value of the Turkish lira in early January, the currency has gained more than 6% against the dollar ytd, rising to its highest level since November on February 1. Equity and bond markets have also rallied, while the government at long last also appears to be making progress on reducing the current account deficit, which fell 7.2% y-o-y in December.
Meanwhile, while HSBC’s January PMI index for Turkey fell to 51.7, from 52.0 in December, it nevertheless indicated a continued expansion of manufacturing activity. Furthermore, the latest trade data showed 10% y-o-y export growth, defying predictions that a slowdown in global demand would further swell the country’s current account deficit.
In a letter to the government this week, Basci outlined his hope that continued currency appreciation could help to tame inflation by bringing down import costs, and insisted that the current policy path would enable the country to tame inflation while achieving a soft landing.
But a growing number of analysts are warning that recent currency strength is merely a temporary reprieve, fuelled by a more general FX rally across emerging markets rather than by genuine investor confidence in Turkish policymaking, and that the risks of a hard landing – or even recession – in the coming quarters, remain pronounced.
According to BarCap’s Koon Chow, Turkey’s attempts to strengthen its exchange rate, tame inflation, reduce its current account deficit and maintain moderately strong growth are contradictory. Policymakers are therefore likely to have to make some tough choices in the coming months.
Chow writes:
| We are forecasting a sharp slowdown in the economy in 2012 but we do not, given “sticky” imports in Turkey especially of energy, expect the current account deficit to fall below 7.5% of GDP from 9.5% in 2011. The greatest dilemma for the CBT is likely to be when the economy slows more aggressively. We have already seen signs of manufacturing and consumer activity flagging. At the latter stages of the slowdown, the CBT may need to choose between supporting growth and the current account adjustment or supporting the lira and containing inflation, which has already been pushed above 10% on the back of last year's depreciation. The risks of the former keep us cautious on the lira and the real test will be if the unfolding slowdown dovetails with another period of risk aversion. |
Meanwhile, in a report released yesterday, Bank of America Merrill Lynch analysts Turker Hamzaoglu, David Hauner and Arko Sen warned that the CBT’s policy mix would drag down GDP growth, which, given the significant macro risks at present, could prove disastrous. They write:
| Despite a slowing economy, Turkey is among the few EMs that have been forced to tighten monetary policy due to the pressure on their FX rates. CBT still prefers ON corridor to change its monetary policy stance over the policy rate, but we think a side effect of sticking to this policy choice for an extended period may be lower GDP growth. Just how much they expect growth to slow makes for uncomfortable reading for Turkish policymakers: Although the government and the private sector remain optimistic on GDP growth this year (consensus 3.3% and the government’s target is 4%), we think the economy already started to contract qoq in 4Q11. We forecast a 2.3% yoy contraction in 1H and 0% full year GDP growth. |
Ouch. Unsurprisingly, they remain extremely bearish on Turkish assets, in particular the currency:
| Turkish assets are at a crossroad, as the economy is likely about to turn down. Since the CBT may opt to lower interest rates as headwinds on growth strengthen, that will likely cap the recent TRY strength through a lower ON rate whenever pressure on the currency eases. Moreover, given the slow pace of current account adjustment and depleting reserves, we remain worried about a tail risk scenario in TRY over the medium term. |
And they add that sudden capital flight remains a significant risk:
| As the fastest growing EMEA country, still with a wide CAD, Turkey is vulnerable to a sudden stop in capital inflows and/or a sharp rise in global risk aversion. Further weakness in TRY may lead to a harder landing for domestic demand. |
This is a particularly gloomy view - consensus growth forecasts are in the region of 3-4%, while supporters of the unorthadox policy mix insist that it will still pay off. But if data turn sour in the coming months, expect the criticism to intensify.
No pressure, then, Mr. Basci.