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.

Monetary Confusion and Credit Cycles

Turkey has been an interesting experience for economists in many aspects. A central bank keeping the real interest rates extremely low in a period when the country suffers from savings gap and high inflation may be among them, despite a good economic performance.

Pretending that the central bank is the only game in town is inherited by the world of quantitative easing, where developing economies are besotted with a cheap money which has been in place for almost a decade. That decade is over and audience does not have any opportunity for a curtain call.

So far you have read a story which you are probably familiar with. From now on, we are solicitous to provide some insight supported by some data about how effective Turkish central bank has been in shaping the credit markets through interest rates. At this point, we look for correlations between loan rates and the average cost of funding rate, which was originally made in Turkey, through a system called “interest rate corridor” in which the central bank can determine the effective fund rate in a considerable wide margin.


The chart above show the 36-week trailing correlation between the effective interest rate between implied by the central bank and the rates for direct consumer, mortgage, commercial lending and deposits.

There has been cycles when apparently central bank lost its control over credit markets. The first cycle, in our view, was solely based on this unorthodox monetary policy framework as discussed above. Having said that, the following two cycles are products of banks’ weakening appetite for lending growth.

We attach important to the last two because it shows when loans to deposit rates when through the roof, banks deliberately lift their rate that loans and deposits carry without a tightening signal for the reserve bank. That is simply how to be functionless in determining the interest rates for the banknotes you issue. This view is also supported by lead-lag analysis that suggests loan growth surprisingly lead interest rates.

November MPC: Waiting For Further Hikes

The monetary policy committee raised 1-week rate by 50 bps to 8% and the upper band by 25 bps to 8.50% vs a consensus expectations split between a 25 bps hike in the 1-week repo change and no change. As a separate decision, the central bank has decreased FX reserve requirements by 50 bps for all maturity brackets, providing $1.5 billion of liquidity to the financial system.

The move came despite the politicians’ strong remarks against high real interest rates, but after Turkish lira has weakened almost 9% against the US dollar (even underperforming the Mexican Peso). To our thinking, this was a rational move but not enough to reduce near term risks. The rate statement noted that despite the disinflationary slowdown in aggregate demand, recent exchange rate movements ─owing to heightened global uncertainty─ posed upside risks to the inflation outlook while it did not provide much forward guidance.

The average cost of funding rate was standing at 7.9% just before the decision, and according to our estimates the rate hike could add another 35 bps, taking it to 8.25% in days to come. That said, we have already seen it rising to 9.05% in two days following the rate decision. We believe much of the devaluation in the local currency has been driven by global market conditions, and Trumpflation trade is likely to lead further downside. While our 2016E USD/TRY target of 3.2 is overshot by a wide margin, we renew our 12-month horizon target at 3.65 for the currency. We also believe that 25 bps hike in the ceiling of the rate corridor may not provide sufficient incentive for deposit holders to stay in TRY.

turkey-real-interest-rate-and-core-inflationPreviously, we draw a pessimistic future for the inflation outlook in 1H17. Correspondingly, we see further rate hikes by the central bank going forward, and expect the average cost of funding to hit 10% next year, in an effort to provide a compelling real interest rate for TRY holder. In our view, the recovery signals in Q4 ─after a dismal Q3─ on the lending growth front, would provide some comfort for the central bank for tightening. That said, we earlier stated that it was more likely to see fiscal stimulus to support the economic activity in the future (we expect Turkish government to post a budget deficit of 2% as of GDP in 2017).