Turkey’s Resilience to a Fed Rate Hike

The effects on emerging markets of unconventional monetary policies implemented by some advanced economies have been a focus of debate. The policy of so-called quantitative easing that the central banks in advanced economies embarked on has increased capital flows to emerging markets. However, as these policies are scheduled to end in the near future and advanced economies are beginning to normalize their monetary policy, we are watching episodes of volatility in global financial markets. For emerging markets improving macroeconomic and financial policy frameworks and developing the financial system is crucially important for intermediating capital flows in a stable and efficient manner.

The quantitative easing had spillover effects on emerging markets through many transmission channels. The compressed term premium of assets in advanced economies increased the demand for all substitute assets including emerging market assets, as investors turn to riskier assets in search of higher expected risk-adjusted returns.

At this juncture, with the European Central Bank now embarking on its own quantitative easing, it is reasonable to ask whether we should expect to see similar on net flows into emerging markets. It is absolutely supportive of capital flows into emerging markets, but the impact will be relatively muted compared to what occurred under the US Federal Reserve quantitative easing. Investors in European assets will face strong incentives to re-balance on non-European assets. However, the small capitalization of European market compared to the United States implies that magnitude of this reallocation will be limited by comparison. Not surprisingly, we have observed a remarkable weakness in capital inflows to emerging markets following the Federal Reserve entering a tightening path despite the European Central Bank injecting liquidity to the market in order to overcome the stagnation across the continent.

By quadrupling their short-term external debt stock in 5 years of quantitative easing, Turkish banks have benefited a lot from the unconventional wave in the world of monetary policy. Analyzing the data with a timeline of the US Federal Reserve’s quantitative easing timeline clarifies the borrowing dynamics of Turkish financial institutions.

Turkey - Banks Short-Term External Debt Stock

In a previous post, we pointed the sluggish credit growth in Turkey and whether it is a cause for concern around Turkey’s growth. The economic activity in the country had been fueled by the fast loan growth such that Turkish central bank turned negative on increasing lending amid qualms about the signs of possible overheating and implied a policy to keep the loan growth rate at a targeted level of 15%. Meanwhile, lending growth in the country had been increasingly dependent on external financing due to mainly two reason. First, eased borrowing conditions in the global due to aforementioned reasons had encouraged the bank in Turkey for external financing. Second, the multi-purpose monetary policy expectedly failed the lower the inflation rates below the targeted level and consequently the deposit growth considerably slowed because of offering a negative return in real terms.

Turkey - Loan and Deposit Growth and Reliance on External Financing

So, within a higher interest environment across the global markets where Turkish lira depreciates against the US Dollar, Turkish banks are expected to deleverage voluntarily. Considering the decreasing roll-over ratios, this might be already underway. On May 8, Standard & Poor’s, the credit rating agency, pointed the issue resulting lower real GDP growth while it cut Turkey’s notch by one level in local currency terms. The agency’s real GDP projections are 3.0%, 3.2%, 2.8% and 2.5% in 2015, 2016, 2017 and 2018, respectively. Additionally, below is its expectations for Turkey’s external financing needs over the course of next four years. It is not even worth to mention that these seem as downside risks to the ratio outlook.

Turkey - External Financing Needs Expectations

The challenge going forward will be achieve a solid foundation for sustained growth amid an international climate dominated by short-term interest rates. Specific to Turkish banking universe, the central bank began paying interest on lira-denominated reserve requirements which was the latest move Governor Erdem Basci to try to boost economic growth without monetary policy easing. However, given the industry has lacked a sufficient deposit growth for a while, with strengthening competition among banks this would result in higher interest rates in Turkish deposit market leading higher funding costs. Following that, the move may cause credit expansion slowing further rather than mitigating the effects of the US Federal Reserve fallout. This is likely to be the key theme in fixed income markets where the high interest rates are here to stay for a while.

Turkey is to face a number of economic challenges once the political turmoil is over and this time it will not easy to blow the clouds away.

Are Rates Still Low Despite The Massive Hike?

The whole world was shocked when Turkish Central Bank raised its policy rate to 10% from a lending rate of 7.75%. Market reacted quickly to this massive hike. We saw lira abruptly gaining value and flirting with 2.17 against dollar, EEM (iShares MSCI Emerging Markets ETF) rallied an so on. But the question still remains. Are rates high enough to attract foreign investors in order to provide the capital inflows towards the country which has the highest foreign debt as of its GDP among major emerging economies.

Here is the most shared chart on Twitter last week:


This chart is also explaining what may happen when policy makers in emerging economies go against the principles of macroeconomics. The negative reel rates era in developed world let the emerging one build welfare economies but not in a sustainable way. The time for repayment is likely closing in. What meant $20 billion Fed tapering to Brazil and Turkey was raising rates.

Should we expect Turkish Central Bank to continue to tightening its policy further? We have some reasons to think so. There are the most important lines from release by the central bank.

Tight monetary policy stance will be sustained until there is a significant improvement in the inflation outlook. Under this policy stance, inflation is expected to reach the 5 percent target by mid-2015

This morning we had the inflation numbers for January that came out higher than market expectations with a 1.72% rise month over month, meanwhile annual inflation rose to 7.48% that is followed by increases in year-end inflation forecasts by global investment banks. Additionally, the survey of expectations made by Turkish Central Bank tells us the similar story.

Turkey - Inflation Expectations

Respondents indicated that, on average, they expect unit costs to rise 7.1% over the next 12 months with a sharp increase from the expectations of 6.7% one month earlier.  2 years-ahead inflation expectations also rose at the end of January. If the trend remains up in next surveys, this will prove that market’s belief that rates are set lower that they should be.