Turkey Inflation: A Year with A Bad Ending

‘Hate to Say I Told You So’ was one of the most iconic songs in early 2000s, performed by the band called The Hives. Now the phrase also reflects my views on the evolution of Turkey’s price stability indicators this year. In line with my (ahead of the curve) expectations, which I shared in a blog post in May (Why Inflation May Not Fell to Single-Digit Figures This Year), the year finished with a double-digit inflation figure in Turkey as the new year also brought no good news.

The prospect of market consensus is now for an inflation rate remaining above 10% until the last quarter as Turkey will hopefully reach a single-digit inflation rate as of Q4 2018. In our view, in case Turkish lira does not face a severe depreciation against major currencies, the improvement in inflation should be faster than market expected, though we remain pessimistic on the outlook of price stability in Turkey mostly due to the central bank’s reluctance of (needed) monetary tightening. From a statistical point of view, all price indicators currently stand at unprecedently high levels based on their historical averages, which should be supportive for an optimistic case. On the other hand, Turkish lira’s long-standing vulnerability to external shocks prevents us from attaching credence to this scenario amid the fears around a pick-up in global inflation.

On a separate note, our long-term caution for rising inflationary pressure in Turkey stems from the relevant dollarization process in the economy as evidenced by individuals’ strengthening demand for deposit account in foreign exchange.  The chart above shows the relationship of the dollarization, which we try to quantify as individuals’ FX deposits as percentage point of M2 monetary base, and the core inflation, which just posted an all-time high in December (for the current series). Note that our VAR analysis suggests dollarization is the leading variable here.

One other thing that should be highlighted would be the deposit rates offered by the banks have been on rising trend recently touching post-financial-crisis era highs as of the year end. This demonstrates the declining level in the efficiency of the monetary policy as the gap between market rates and the average cost of funding rate widens. This somehow could limit the dollarization to some extent, but Turkish central bank will eventually to need to keep real rates high to stabilize the local currency as well as the prices, and to regain its credibility. Sadly, this primarily requires to be given the green light by some authorities other than the policymakers at the central bank.

A Brief History of Monetary Orthodoxy in Turkey

Since late 2010, the Central Bank of Turkey has been employing unconventional monetary policy tools primarily for price stability, and creating an environment conducive for economic development. It is hard to tell the reserve bank has succeeded in the former, and Turkey’s track record of economic growth is disputable.

Now with the CPI growth standing at the highest levels since the inflation targeting implied and fiscal policy being eased to spur the growth which has been rarely observed during the AK governments that are known for the determination to keep the public debt/GDP ratio at the low levels, it is time to look back and see how we ended up here. Please take a moment to look at the chart below.

Also note that the CBT’s average cost of funding hit its highest point at 11.96% last Friday (5/5/2017) since the the global financial crisis period.

Mortgage Boom in the Making

Construction sector has maintained a significant role for Turkish economy in recent years as house prices in mega cities have skyrocketed and government sponsored large projects have been under way. Now with the economy sending signals of slowdown, we not surprisingly saw some attempts to boost the industry which has been at the forefront of the country’s recent economic development. Other than transforming the skyline of Istanbul, ─admittedly not many residents of the city take a fancy to this─ this may have some unexpected and unintended implications for the economy.

Not to mention the bubble it has created and possibility of economy toppled once it bursts, we currently observe strange findings in the financial space. First, Turkish central bank has increased its average cost of funding rate, in other words the effective rate, via some unconventional methods such as acting solely as a lender of last resort rather than a central bank. Meanwhile, mortgage rates have kept falling like dead leaves and now the average rate for the mortgage production is lower than the effective rate the central bank implied, which means Turkish banks provide mortgage loans at a loss. While banks are able to offset the loss via some fees and cross selling activities, we see it as long-term risk as rates are set to be higher in the upcoming period that would leave lenders with significant interest rate and liquidity risks. Please note that banks in Turkey are still not comfortable with the funding side.

So, the question may arise as to which segment of the banking records high origination activity recently. It comes as no surprise that state-run banks again take the lead in mortgage market and outperforming the rest of the industry by a wide margin.

With naysayers in the banking community now having the upper hand across the board, one would imagine the conservative and high quality underwriting standards and solid risk management in Turkish banks where regulations have been extremely strict but functioning well, but not, likely as a part of the ongoing “structural deform” process.