beyondbrics

By Christian Keller of Barclays Capital

The central banks of Turkey (CBT) and Hungary (NBH) both left their policy rates unchanged on Tuesday – the CBT at 5.75 per cent and the NBH at 6.00 per cent - as widely expected.

But this is about where the similarities end. Indeed, the Turkey-versus-Hungary comparison is perhaps the starkest example of the macroeconomic contrasts within the EEMEA region and also of the different policy responses of the respective central banks.

Hungary is one of the weakest recovery stories in the region, with its GDP still below pre-crisis levels. Importantly, the output recovery has been driven purely by net export growth, which also moved the economy’s current account into a surplus.

Domestic demand remains very weak, as households are burdened with high mortgage debts, mainly denominated in Swiss francs, and the government is committed to fiscal deficit reduction. Inflation rose temporarily due to tax increases, but absent any demand pressures, it has been moderating faster than expected and is moving towards the 3 per cent target.

Fiscal sustainability is considered a risk, with a public debt ratio close to 80 per cent of GDP, which this year is being reduced mainly by what amounts to a forced re-nationalisation of private pension assets.

As the charts below show, Turkey is at the opposite end of the policy spectrum from Hungary.

The second chart shows the development of exchange rates of lira and forint:

Turkey was one of the world’s fastest growing countries in the first half of 2011, with its GDP now well beyond pre-crisis levels. Output growth is driven by credit-fuelled consumption, which has created a large current account deficit approaching 10 per cent of GDP in 2011. Headline inflation has been very volatile, but recently even core inflation seems to be moving steadily above target.

With an under-developed mortgage market, households have limited debt burdens and almost none in foreign exchange. Indeed, households in aggregate are ‘long FX’, given their large FX deposits in the local banking system (the consequence of past decades of high inflation).

Turkey’s fiscal sustainability is strong, with a public debt-to-GDP ratio about half that of Hungary, and the government’s ability to issue local currency debt at interest rates below its nominal GDP growth rate.

Reading these two profiles, it’s not obvious why the two central banks have kept their policy interest rates at current levels.

Hungary has one of the highest real rates in the region – around 3 per cent – and the NBH actually hiked the rate in Q4 10-Q1 11 in order to stabilise the HUF exchange rate.

During the same period, Turkey’s CBT cut its policy rates, setting one of the lowest real policy rates in the region. While the real policy rate has been hovering around zero to negative for many months, the CBT has been trying to slow credit growth with higher reserve requirement ratios and other prudential measures.

Indeed, in a surprise move in early August, the CBT lowered the policy rate again in an extraordinary meeting, pointing to signs of a deterioration of the global growth environment. Turkey’s policy rate has been hovering around zero to negative for many months.

The difference can mainly be seen in the development of the exchange rate. HUF has remained relatively stable against euro over the past year, with volatility visibly reduced as a result of the NBH’s rate hikes.

Currency stability serves the NBH as it aims to limit the household sector’s burden to service its foreign exchange debts. In contrast, the CBT essentially purposefully engineered a lira weakening with its policy rate cuts, as it aims to address Turkey’s growing external imbalances. However, these policies have trade-offs: Hungary’s high interest rate does not help stimulating domestic forint lending; Turkey’ weak exchange rate does not help in moderating inflation.

Where to from here? The NBH still faces a difficult task. Although it managed to keep forint stable against euro, it still depreciated against Swiss franc, the currency in which Hungary’s households have more than 15 per cent of GDP in debt.

A government scheme to allow households to temporarily service Swiss franc debt at a fixed exchange rate of 180 against Hungarian forint (versus 240 at current fixing) does not solve the problem but only shifts it into the future.

Considering the growth and inflation outlook, the NBH could cut rates. But it needs to weigh the potential benefits against potential risk of forint depreciation, in particular in light of the euro area debt crisis. Resolving the latter was critical for it to consider rate cuts, the NBH communicated on Tuesday.

The CBT faces challenges as well, as it seems to be getting more Turkish lira weakness than it asked for. CBT’s recent communication clearly reveals increasing concern about the depreciation pace. Indeed, the CBT governor even resorted to the unusual step of commenting on the fair value of the Turkish lira, suggesting that TRY was ’5-10 per cent undervalued’.

This was likely aimed at the local retail savers. Following the Lehman crisis, the central bank typically bought lira in periods of weakness, helping to feed Turkish corporates’ constant demand for foreign exchange, as they need to pay import bills and to service foreign exchange debt. But now local retail investors has become more cautious, being unsure how weak the lira may go. This is a development the CBT cannot ignore.

Moreover, the weaker lira will also drive inflation higher in coming months. This could adversely impact inflation expectations which thus far have remained relatively well behaved.

The CBT insists that higher inflation will be temporary, but rising CPI numbers could start affecting its credibility. Last but not least, Turkey needs to continue to attract large capital flows to finance its external financing requirements, as the current account is likely to adjust only gradually and with some delay. Prospects of falling interest rates may attract some additional flows into the local bond market, but on balance further rate cuts would probably make Turkish lira more vulnerable. Thus, as much as the pro-growth central bank seems tempted to ease policies further, we think exchange rate concerns could limit its ambitions until Turkey’s external imbalances start to improve visibly.

Christian Keller is head of emerging Europe research at Barclays Capital

Related reading:
More from Christian Keller: CEE lessons for Greece
Time to revisit Turkey, beyondbrics
CEE: will the IMF have to help out again?, beyondbrics