beyondbrics

This post is the second of a series – 12 for 2012 – that beyondbrics is running on key emerging markets topics for the coming year.

By Murat Üçer

Thanks to ample external financing and lots of government-backed economic stimulus over the past two years, Turkey’s output is some 10 per cent higher than pre-crisis levels. For sure, this is something to boast about.

But at the same time, the current account deficit has soared from around 6 per cent of GDP to 10 per cent and inflation is at 10 per cent. The authorities have tried to manage the boom with some controversial and complex tools over the last year, notably unorthodox monetary policy. But if Turkey is to avoid more trouble ahead , a stronger and more orthodox policy response is needed as soon as possible.

So far, the central bank has not succeeded in its effort to crack the so-called ‘impossible trinity’ – a well-known dictum of macroeconomics that stipulates that one cannot set both the interest rate and the exchange rate in an open capital account regime. Its unorthodox combination of low interest rates with higher reserve requirements has not turned out exactly the way the bank hoped when it introduced the framework a year ago.

The new set-up was never fully understood and/or endorsed by analysts, but it took a ‘sudden stop’ of capital inflows this autumn to expose its brittleness. Faced with a tighter external financing environment, the lira depreciated a lot more than envisaged, which, combined with other factors (like tax hikes, a strong economy, elevated food prices) led to an inflation rate of around 10 per cent.

The bank claims inflation will ease back to the 5 per cent target by the end of 2012, but other than the expected base effects, the reasons for this are unclear. Inflation expectations are over 7 per cent, pointing to a significant ‘credibility gap’ for now.

As for the current account deficit, the consensus holds that this may decelerate to some 8-9 per cent of GDP next year, but unless the economy contracts or oil prices collapse, no one projects the current account deficit to retreat to pre-crisis levels of around 6 per cent any time soon.

So as we enter 2012, we have had an impressive recovery perhaps, but macro imbalances have worsened sharply. Politicians, understandably so, like to emphasise the recovery, but markets, rating agencies, and most recently the IMF are concerned about the growing vulnerabilities, given the difficult global backdrop.

In any event, the heightened risks of a relatively hard-ish landing underscore the need for tighter, more forward-looking policies. We think such policies would entail at least two elements in the short term: monetary policy has to become simple and predictable again, while fiscal policy has to shift its focus forcefully to the current account deficit.

Let us start with monetary policy. As we’ve already suggested, the record so far is not particularly encouraging. While grappling with the impossible trinity, the bank’s new framework, in the words of a recent IMF Board statement, “has not demonstrated it can deliver price- or financial stability.” Of late, the bank has put a stronger emphasis on curbing credit growth as a panacea of sorts, but a solid analytical framework as to how the bank’s multiple targets and instruments hang together, has yet to be fleshed out.

The bank also likes its wide ‘interest rate corridor’ because of the flexibility, but seems to neglect that this flexibility comes at a huge cost: predictability for economic agents, because the benchmark lending rate varies so wildly, between a very high overnight rate (12.5 per cent) and a much lower policy rate (weekly repo at 5.75 per cent).

Unorthodoxy is fashionable nowadays, but it’s probably better to stick to basics: simple is good in policy design, because we don’t know enough about the structure of the economy. No wonder, then, following the hyperactivity of the past year, we now have deteriorating expectations and poor visibility of the economic outlook. Another important point is that, policy errors prove more costly when the starting point is one of a chronic savings shortfall, as it is in Turkey, and an onerous external financing requirement. The external financing for 2012 is near $200 billion, comprising a current account deficit of some $60-$65 billion and short-term debt rollovers of $135 billion. When this is the case, being simple and predictable becomes not just desirable, but simply vital.

On the fiscal policy front, we also have an illusion of sorts. A low deficit of around 1-2 per cent of GDP and a government debt-to-GDP ratio of around 40 per cent today are surely commendable. But, more is necessary on the fiscal side to contain the current account deficit, because the most direct way to raise a country’s overall savings is to raise its public savings. Put differently, fiscal targets need to be a lot more ambitious if the running current account deficit is around 8-9 per cent of GDP, simply because even if private savings drop a bit in the face of tighter fiscal policies, higher public savings typically lead to higher overall savings.

Finally, a vigorous refocusing of monetary and fiscal policy on price stability and a narrowing of the saving gap, should go hand-in-hand with the formulation of a detailed and well-prioritised structural reform strategy to bring about a strong supply response, with, for example, labour market reforms (to improve the flexibility and skill levels of the labour force), tax reforms, and corporate governance reforms for small and medium-sized enterprises.

Because without such a supply response, at any rate, it is hard to achieve growth rates that Turkey needs – 5 per cent or more – without producing significant imbalances, including high inflation and/or a rising current account deficit.

None of this stuff is novel or complicated for seasoned observers of the Turkish economy with a solid command of Economics 101. This is exactly the point: it’s time go back to basics – and do so, urgently!

Murat Üçer is an adviser to Global Source Partners

Related reading:
Turkey’s central bank: in a bind, beyondbrics
Special report: Turkey, FT
Turkey: slowdown or smash up? beyondbrics
Turkey’s unorthodox orthodoxy, beyondbrics
Series: 12 for 2012