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 At this point, we look for correlations between loan rates and the average cost of funding rate, which was originally made in Turkey, through a system called “interest rate corridor” in which the central bank can determine the effective fund rate in a considerable wide margin.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.

March Inflation: Big Downside Surprise

Consumer Price Index inflation in Turkey surprised significantly on the downside in March on the back of falling food prices. According to the data released by the official statistics office annual inflation slowed to 7.5% y/y from 8.8% in February. On a m/m basis it remained stable being well below the consensus of 0.5%. However, the improvement in core inflation was less satisfactory as the I index (core inflation) only lowered by 21 basis points to 9.5%.

Turkey Inflation - Headline versus Core

Turkey Food Price Inflation

Note that the food price inflation for March at 4.1% was the lowest figure recorded since May 2012, and Turkey has been able to post single-digit annual inflation in food prices only 7 times over the past 34 months. Interestingly, March inflation was negative for the first time since 1973. The divergence between headline and core inflation reached 2.05% with lower food and oil prices, which may lead consumer confidence increasing in the following months.

The impact of the hike in national minimum wage on services prices is to keep core inflation rate higher for a while. On a positive note, the decline in the core inflation signaled a weakening pass-through effect as Turkish lira relatively remained strong.

We expect the headline inflation to remain in the 7.5%-8% range and end the year above 8%. Within this perspective we foresee Turkish central bank continuing with rate cuts of 25 basis points on the upper band of the interest rate corridor each over the next two months. We also see further rates unlikely because of the risks including higher inflation expectations in the second half of the year and deteriorating emerging risk sentiment that would hit the local currency as real rate in Turkey are still lower than EM peers at the moment.

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.