The Kapali Carsi

The ‘M’ Is There for a Reason

When a friend asked me the other day whether the International Monetary Fund, or IMF, was asking Turkey to raise interest rates, my weekly stressful search for a topic was over.

The IMF published the preliminary conclusions for its combined Article IV and post-program monitoring missions at the end of May, which fell victim to my inaugural interview last week. I also thought that almost everything the Fund was saying made sense; ergo devoting a column seemed redundant. But now that I have read about all the Fund-bashing in the media and research reports, I decided it might yet be important to share my views.

My only major disagreement with the report is in its assessment of past fiscal performance. The Fund ties much of the fiscal laxness of the last couple of years to “cyclical revenue loss,” ignoring the contribution of rapid expenditure growth. But then, the Fund is much more conservative in its assessment of the future, urging the government not to become complacent by increasing expenditures and enacting revenue-reducing policy changes. Incidentally, this argument for saving the fiscal overshooting, with which I could not agree more, was one of the sensitive issues during the standby negotiations, and one of my key arguments on why there would be no deal.

The Fund also endorses the fiscal rule with few reservations, noting only that its success would “ultimately depend on the strength of commitment to implementing the rule’s provisions.” Given Turkey’s fiscal track record, I am astonished by this almost-blind confidence, but the Fund would never be as tactless as your friendly neighborhood economist. I would have also expected, especially given its warnings on future fiscal policy, for the Fund to argue for tighter parameters in the rule.

But the shocker of the report is monetary policy, where the Fund is recommending that “the pace of tightening should be accelerated in view of elevated inflation expectations and rapidly growing bank credit, while at the same time stepping up foreign currency purchases [to] rebuild reserve cover more quickly and help alleviate excessive upward exchange rate pressures.” The Fund argues that not doing so could lead to a further deterioration in inflation expectations, which would enforce higher nominal rates and attract hot money. Besides, hiking policy rates abruptly to re-anchor inflation expectations could be disruptive because of banks’ maturity mismatches.

I can see my colleagues making fun of this prescription when the Central Bank’s bi-monthly survey registers a sharp drop in inflation expectations on June 8. Never mind that given how adaptive those expectations are, such a fall would be natural after May inflation, at -0.36 percent month-on-month, or MoM, turned out be significantly lower than expectations. Or that the figure was entirely driven by the -4.38 percent MoM food inflation, and the volatility of food prices all but ensures that it is way too early to claim that the negative food supply shock is over.

In fact, having written about the surge in credit demand and stronger-than-expected recovery several times, I could not agree more with the Fund’s advice. Besides, the current chronic lira liquidity shortage is conducive to implementing foreign currency interventions, and sterilization would be a walk in the park. But given the risk of external demand weakness resurfacing, owing to euro area’s woes, and its extremely pro-growth stance, the Central Bank just cannot afford to implement these recommendations, although I am sure it is well aware of the risks.

But it could pay off to heed the IMF’s warnings a bit; after all, the “M” is there for a reason.

This article originally appeared at The Hurriyet Daily News and has been reproduced here with permission.

Addendum 1:

I have quite a bit of additional points: First, the Fund makes the following policy recommendation in the report:

Policies should aim at containing domestic demand and lowering the relative price of locally supplied products to help support net exports. Policies to promote domestic saving will also reduce reliance on volatile short-term capital inflows to finance investment

I agree wholeheartedly with this statement, but as the few sensible Turkish economists (I am using the word to denote professional area of coverage/interest rather than citizenship or nationality) like Cevdet Akcay and Murat Ucer, as well as your friendly neighborhood economist, have noted, this is easier said than done…
On the Turkish economy’s disruption from the crisis, the Fund has this to say:

The aforementioned policy reforms kept pre-crisis vulnerabilities more contained than elsewhere in the region, enabling Turkey to better weather the ensuing international economic and financial disruption.

I agree, and have argued before, that Turkey enacted a successful macro reform agenda, which was not followed by micro reforms, by the way. But these reforms, along with other favorable conditions like sound banking system (actually a “casualty” of the reform), relatively low dependence on external demand and lack of a strong credit/asset boom, meant that Turkey seemed well-poised to be one of the countries least-affected by the crisis, but things didn’t work out that way. So saying that Turkey weathered the crisis well is an understatement at best. I think the question that needs to be asked is this: Despite these favorable conditions, why did the Turkish economy contract so much in 2009?
A recent IMF paper asks why some countries were hit harder by the crisis, and a CBT paper concentrates on Turkey. Both papers imply that Turkey’s trade links disrupted growth more than predicted by the size of its exports because of the composition of trade (too many cyclical goods) and the country’s trading partners (mainly EU).
Leaving this interesting side point aside, a final point I’d like to add in on the case for policy rate hikes: While the IMF report concentrates on domestic factors only, the expected tightening in systemically important emerging market, or EM, countries could make put a further strain on the CBT’s on-hold-for-longer strategy. After all, even today, Turkey has the lowest real policy rates in the EM universe.

Addendum 2:

I don’t like to tell you I told you so, but I did tell you. To quote directly from the column:

I can see my colleagues making fun of this prescription when the Central Bank’s bi-monthly survey registers a sharp drop in inflation expectations on June 8.

To illustrate:
But I shouldn’t brag too much; given how adaptive these expectations are, guessing that they would drop sharply after the lower-than-expected inflation print was a no-brainer.
But this raises the question how reliable those expectations are in the first place. There are ways to get inflation expectations as implied by asset prices, on which I remember to have written, so I’ll relink that post if I can find it.

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