It’s time to rip apart those orthodox monetary economic textbooks – perhaps.
In 2011, Turkey was facing, what many analysts were expecting at least, an old-school emerging market crisis: spiraling credit growth, a current account gap and monetary policy impotence. Shorting the lira, betting that country's central bank Governor Erdem Basci was playing with fire, was the consensus trade du jour. What’s more, Turkey – along with Ukraine – was seen as one of the most vulnerable EMEA economies to a reversal of foreign portfolio flows, given its modest FX reserves position and high external financing requirements , which is structurally large due to high energy imports.
But in the fourth quarter, signs emerged that perhaps, just perhaps, Turkey was winning the battle with inflation easing despite the monetary policy mix focusing on hiking banks' reserve requirements while keep interest rates low (at the cost of spiraling credit growth, of course.)
Fast-forward to this week: and Turkish bulls have a spring in the their step given the emergence of promising data on Monday, which showed that the current account deficit for 2011 totalled $77.1 billion, equal to 10% of GDP and up from 6.5% in 2010.
The deficit is largely financed by short-term inflows into debt and equity inflows rather than more stable foreign direct investment, making it especially vulnerable to a sudden stop in financing flows. That’s Turkey’s well-known menace.
This situation would be worrying at any time, but doubly so at a time when the investment climate is as volatile and uncertain as it has been recently. Meanwhile, the central bank’s unorthodox monetary policy encourages the impression that the stewards of the economy are paying no heed to the risks of overheating: In August, with the deficit yawning wider and private credit growth running at around 40% year-on-year, it decided an interest rate cut was the best way forward.
Day of reckoning
BUT markets have treated Turkey amazingly gently even during the worst of last year’s market wobbles. Yields on the 10-year government bond showed relatively little evidence of stress - even falling during a number of tense periods – and closed 2011 in the same area where it spent most of the year, at around 9.5%. And while the lira was a very poor performer in the first half of the year, it performed in line with similar emerging market currencies thereafter, even during the third-quarter panic.
However, markets are on something of a rally since the current account deficit seems to be on an improving trend. The monthly figure for December 2011 was lower than in December 2010.
Domestic credit growth seems to be cooling since the central bank reversed course slightly and began tightening overnight interest rates in October (although even now its approach remains unorthodox, with the benchmark lending rate much lower but access to loans at these rates rationed – an approach that seems to baffle most outside analysts. And the lira has strengthened from a record low of 1.92/USD at end December to 1.76/USD now.
Thus, the spirited resurgence in risk appetite and fund flows to EMEA equities and local currency governments bode well for
Turkey’s bid to finance its current account deficit – for now.
As a result, many analysts who expected a very tough 2012 for the economy are shading their views somewhat. Here’s what
Jonathan Anderson of UBS had to say a week or so ago:
| “Two very interesting and promising things have happened [the stablising lira and the central bank’s moves to tighten] – not enough to make us rush into Turkish assets today, mind you, but certainly enough to make us a lot more sanguine on the 2012 outlook (and related risks) as a whole.” |
Or Capital Economics on the latest current account data:
| “... the risks to our forecast for the Turkish economy to contract by 1% this year are skewed to the upside ...” |
While few analysts are actually turning bullish yet – for example, Capital Economics adds that it still sees Turkey as very vulnerable to contagion – markets have fewer doubts. Istanbul stocks have played a major part in the EM risk rally, up 17% year-to-date.
In sum, near-term financing risks have been reduced sharply relative to market consensus six months or so ago. So IF Turkey does prove conventional monetary economists wrong – it could prove an interesting case-study for other EM policy-makers on the trade-off between exchange rate stability, inflation and (relatively) open capital accounts.
On the flipside, were global market conditions to darken – Turkey has sown the seeds for its own disaster with gung-ho pro-credit growth policies.
Additional reporting by Cris Sholto Heaton