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Western EuropeSeptember 3 2012

Will unorthodox thinking keep Turkey's economy stable?

Turkey’s central bank has apparently achieved the impossible by successfully tackling inflation, stabilising the country's currency and combating speculative inflows through an unconventional mix of interest rate cuts and tweaking reserve requirements. But can these changes hold up against the changing economic climate?
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Will unorthodox thinking keep Turkey's economy stable?

Since December 2010, the Central Bank of the Republic of Turkey (CBRT) has been pursuing its main policy goals of bringing down inflation, holding the Turkish lira stable, controlling the current account deficit and combating speculative inflows through a policy mix that has been variously dubbed, criticised and even on occasion derided as 'unorthodox', 'unconventional', 'neo-modern', and even 'neo-post modern'.

Certainly controlling the exchange rate and inflows of speculative 'hot money' by means of a variable interest rate corridor – and tweaking reserve requirement ratios (RRR) using an arcane table of coefficients to put a cap on credit growth – is unusual.

Instead of maintaining a single benchmark interest rate, as is the norm, the CBRT has operated with a selection box of overnight, weekly and monthly rates in an interest rate corridor in which the 5% overnight borrowing rate marks the lower margin and the 11.5% overnight lending rate the upper margin.

Additionally, in order to keep a lid on credit growth, the CBRT has hiked RRRs to 10% while at the same time meeting the lira liquidity needs of the banks by permitting them to keep a percentage of their reserves in foreign exchange (FX) instead of lira.

In August, the CBRT raised the percentage of the reserves which banks may hold in FX from 55% to 60%, albeit divided into bands, with the levels of what has to be held calculated using a complex set of coefficients. “Up to 40% of the Turkish lira reserves can be held in the equivalent value of FX, then for 40% to 45% for every lira the banks have to hold 1.4 liras equivalent of FX and so on,” says Inan Demir, chief economist at Finansbank. “The central bank varies these coefficients, so for every lira of reserves the banks might have to hold 2 liras of FX.”

Just to complicate matters further, the CBRT also allows banks to hold up to 25% of their reserves in gold, a policy twist introduced specifically to encourage banks to collect 'under-the-pillow' gold held by their customers, a neat trick that has encouraged those Turks who want to save to put their savings to use in the economy, while at the same time freeing up some more liquidity for the banks.

Mixed results

The policy mix has had its fair share of critics, not least among Turkey’s banks. While giving the CBRT the flexibility to respond quickly to the fast-changing global environment, it comes at the expense of enormous uncertainty for the markets, with banks facing the problem of having to set their interest rate margins with no fixed interest rate to work from.

Headline inflation should start to fall markedly from October onwards, which should give them a more comfortable environment

Inan Demir

“The major problem with the policy is that it put a lot of pressure on the net interest margin of the banking system because it made the cost of funding more expensive but didn’t give the banks a chance to reflect that in their asset sides,” says Omer Aras, chairman and CEO of Finansbank.

In response to this, the CBRT attempted to introduce a level of predictability by regularly disclosing the minimum amount to which it would fund the banks at its given policy rate and starting one month repo auctions to broaden funding maturity. However, poor inflation figures and a growing current account deficit in the second half of 2011 sparked a loss of confidence in its policies, causing a 35% drop in the value of the lira against the dollar.

With the lira’s position worsening in late 2011, the CBRT was forced to intervene. Faced with general incomprehension at the CBRT’s response, the bank's governor, Erdem Basci, announced that the bank was varying its response on a daily basis depending on whether it deemed a given day to be “normal” or “exceptional”.

On “normal” days, he explained, the bank would sell only $50m in currency auctions, keeping funding costs for banks at between 5.75% and 8% by offering between Tl3bn ($1.67bn) to Tl7bn in weekly repo auctions. In contrast, on “exceptional” days, the bank would not fund the markets at all at the policy rate and would intervene directly in the currency markets as deemed necessary.

While the variable policy brought a swift stabilisation of the lira, it also led to a substantial tightening of monetary conditions, which has begun to ease in the second half of 2012. “During the first half of the year, there was a significant monetary tightening in the market with the average cost of repo reaching close to 11%,” says Cihan Saraoglu, banking analyst at Istanbul brokerage Ekspres Invest.

There was worse to come in May this year when consistently higher-than-anticipated inflation figures hit a three-year high at 11.14% and it appeared that the unorthodox was doomed to be 'unworkable'. As ever, though, no crisis is any more enduring than the next set of figures, and subsequent data releases have indicated that the policies may be having a more positive effect than previously thought.

Predicting progress 

Despite the criticism of its policies, by mid-2012 the CBRT’s unorthodox mix appeared to be bearing fruit, with Turkey’s state statistics body, TUIK, announcing in late July that its benchmark consumer price inflation rate had dropped to 8.9% in June, and with the central bank revising its prediction for end-of-year inflation down to 6.2% and predicting it to stabilise at about 5% by the end of 2013.

Although viewed as still rather optimistic by many analysts, the predictions are not that far from those made by the World Bank in June. Commenting that Turkey had succeeded in making a “soft landing” despite the travails of European markets, the World Bank predicted end-of-year inflation of 7%, falling to 5.2% by the end of 2013, and 5% during the subsequent three years.

According to Mr Demir, the immediate future may offer the CBRT more room for movement. “Headline inflation should start to fall markedly from October onwards, which should give them a more comfortable environment,” he says.

Indeed, in his interest rate statement in mid-August, Mr Basci confirmed that the 5.75% policy interest rate would remain unchanged and increased the percentage of reserves that banks can hold in FX from 55% to 60%. More significantly, though, Mr Basci hinted at a future narrowing of the interest rate corridor and greater use of the reserve requirement coefficients as a means of controlling monetary policy.

“The CBRT will use a narrow interest rate corridor, but if we see large-scale monetary expansion globally it will shift to tightening through reserve requirement ratios,” says Mr Demir.

Risks ahead

The CBRT’s unorthodox policies were introduced in response to the challenging global economic environment, but the success of these policies will depend on the bank’s ability to correctly predict and react to the changing financial climate.

In his latest statement on inflation, Mr Basci confirmed that, given the 20% drop in global oil prices over the first seven months of 2012, the CBRT's inflation expectations are based on global crude oil prices averaging $100 a barrel for the remainder of 2012 and $100 in 2013.

It is an important assumption, considering Turkey relies on imports for 90% of its crude oil needs and close to 100% of its natural gas – the price of which is pegged to global crude prices.

Turkey’s gas-burning power plants may only account for 30% of the country’s total capacity, but their ability to respond quickly to increased demand have regularly seen them meeting more than 50% of the country’s power demand – a level of dependence that is scheduled to increase before long-planned nuclear power plants are completed in the coming five to 10 years.

With the cost of energy imports running at about $25bn a year, CBRT studies estimate that every $10 added to the price of a barrel of oil adds 0.4 percentage points to Turkey’s year-end inflation rate, and adds $4bn to Turkey’s current account deficit.

While news in July that Turkey had succeeded in trimming $2bn off its current account deficit for May was greeted as further good news, it came with the proviso that much of the drop was due to a combination of falling oil prices and some short-term increases in Turkish exports.

According to Mr Demir, Turkey remains particularly vulnerable to regional instability in potential flashpoints such as Syria and Iran, which could force up the price of crude. Equally worrying, he says, is the possibility of further turmoil in the eurozone forcing the oil price down but that would also hit Turkish exports to Europe, which have already dropped from 48.2% to 37.1% of total over the past year.

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