beyondbrics

What on earth is going on in Turkey? That is a polite way of putting the question reverberating around financial markets on Thursday after the central bank’s shock reduction in its policy interest rate, from 6.25 to 5.75 per cent a year.

“They’ve been sailing dangerously close to the wind for a long time,” Nicholas Spiro of Spiro Sovereign Strategy told beyondbrics. “Their strategy was always unconventional but a lot of us were prepared to give them the benefit of the doubt. Now, in terms of inflation-fighting credentials, they’ve blown it. This undermines everything they’ve been doing for the past six months.”

Turkey’s unorthodox approach to monetary policy has been testing investors’ patience since December, when it began cutting interest rates in a counter-intuitive bid to control an overheating economy. Its rationale: if you tackle inflation by raising rates, that attracts hot money and pushes up the currency, hurting competitiveness. By lowering rates, you deter hot money and weaken the currency. Any increase in credit can be tackled by “macro-prudential” measures such as bigger reserve requirements (the share of their deposits that banks must park at the central bank).

Underlying this argument is a belief that the core problem is not price stability but broader financial stability and the priority is to address the current account deficit by curbing inflows while restraining domestic demand. As Spiro notes, this approach has its merits and they have been, if not endorsed, at least recognised by the IMF and the World Bank.

Trouble is, it doesn’t seem to be working. Turkey’s current account deficit is a frightening 8 per cent of GDP and is expected to hit 10 per cent before the end of the year. And the deficit is badly funded, with only about 15 per cent covered by foreign direct investment and the rest by portfolio flows.

Nor is inflation coming under control. The headline figure is at about 6.3 per cent a year, above the central bank’s (current and frequently adjusted) target of 5.5 per cent. Core inflation is also pushing upwards.

The only sign that the policy is working is in GDP growth, which was 8.9 per cent last year and 11 per cent in the first quarter of 2011, but is expected to slow to about 6 per cent for the full year.

But even here, the jury is still out. Many economists are revising their growth estimates upwards. And Turkey’s central bank has said throughout that it would consider raising rates if circumstances demanded. So how can it possibly justify a cut now?

The bank’s statement is quite clear:

Concerns regarding sovereign debt problems in some European economies and the global growth outlook have continued to intensify… the Committee has delivered a measured policy rate cut to reduce the risk of a domestic recession that may be caused by the heightened problems in the global economy.

Does the central bank, previously worried by overheating, now believe Turkey is heading into recession?

Or, as Imran Ahmad at RBS put it: “Is Turkey leading where others will have to follow?”

He told beyondbrics: “RBS has had a ‘rates lower for longer’ view in Europe generally. But now we’re getting evidence that there is something more malign going on. European periphery growth has been very weak and the US debt ceiling concerns have reminded us that these countries are very indebted. Several countries have had rates on hold and the markets have been discussing increases. Suddenly they could become candidates for pre-emptive cuts, which could quickly become necessary cuts.”

As Ahmad points out, the trouble with this reasoning is that, if its focus has switched from inflation to recession, the central bank should also be reversing its macro-prudential measures. In fact, on Thursday it also raised the interbank borrowing rate – which reduces liquidity and would exacerbate rather than relieve any recession.

Whatever it is up to, one thing is for sure: the central bank’s credibility has taken a dangerous plunge.