Tuesday, 29 November 2011

Hard Liquor, Loose Women . . . And Interest Rates

You really have to feel for Ali Babacan, the head of the Turkish treasury, you really do. He is very bright and understands extremely well the complexities of the global financial markets and the key role of interest rates in navigating through those markets.  Yet, unfortunately, his job is made extremely difficult by many fellow government ministers, including the prime minister, who are ideologically opposed to interest rates per se and tend to view them along with hard liquor and loose women as spawns of the devil.

Babacan is constantly forced into defensive and somewhat silly explanations of this clash between reality and ideology without seeming to contradict the prime minister who has a notorious dislike of any dissent.  “My prime minister’s will for a zero real interest rate is an ideal target. That is an ideal target which we would really like to see at one point, but that point might not be so close,” the beleaguered Treasury chief said in a recent Wall Street Journal interview. Very careful understatement, that.

The Turkish economy is going through a particularly dangerous period right now, and the prime minister’s zero interest rate goal is starting to resemble the fanciful foreign policy zero problems strategy.  The zero interest goal is morphing into high rates and multiple problems. Babacan’s efforts to resolve the ideological positions of many of his fellow cabinet members and financial reality have led to some odd contortions that strain the credibility of Turkish financial policy. Whether the prime minister likes it or not Turkey’s economic policy is closely bound to Europe, and the same forces creating so much trouble in Europe are rapidly making themselves felt in Turkey. With the currency depreciating rapidly, personal and corporate debt increasing to record levels and inflation headed back to double digits rates in Turkey are set to head north quickly.

And as interest rates head inexorably northward we can expect consumption to slow down, thousands of apartments remaining unsold, government funding becoming more difficult, massive new infrastructure projects remaining on the drawing board, and unemployment rising. Not welcome news to a government that has won the last two elections on the back of strong economic performance.

Growth At A High Price

A little background will help make this clear. For much of the last 9 years the Turkish economy has boomed on the back of a strong currency and low interest rates. Until a few years ago personal and corporate debt were extremely limited, held in check by Turkey’s chronic high inflation and interest rates. Credit card debt was just beginning and mortgages were almost non-existent.  After its own crisis in 2001 Turkey implemented  IMF-approved reforms that had the desired effect of lowering inflation and interest rates. The currency strengthened and the country began a 10-year run of high growth. Credit expanded rapidly, consumers discovered the joy of loading up their credit cards, contractors borrowed heavily to satisfy the incredible building boom all over the country. And why not? Interest rates were low and the relatively strong currency encouraged massive imports to meet demand for industrial material and the latest consumer goods from all over the world. Expensive imported cars were the order of the day.

Kool-Aid, Anyone?

A few notes of caution were raised about the escalating Current Account Deficit (roughly, imports are much more than exports), but they were drowned out in the self-congratulatory celebrations of high growth, low rates and continued currency strength. It was cheap to borrow in foreign currency and repay with a strong, stable currency. And borrow they did. Officials were in no mood to listen to warnings that this rapid ride might end in tears with an equally strong down-turn. It wasn’t just the officials. Bankers and financial market players were all drinking the same Kool-Aid, and they kept telling people that a new day had dawned and Turkey would be able to fund its deficits indefinitely. The Turkish Lira was to become the new, stable model for developing countries. Turkey’s newly assertive foreign policy was supported by this strong economic growth. Listening to the prime minister Turkey was about to assume its rightful place alongside Brazil, India, Russia and China as one of the major winners of the young 21st Century. Or was it? Had the hype gotten ahead of reality?

The first warning bell was sounded by the current account deficit that was on track to reach nearly 10% of Gross National Product – a dangerous level in any country. The problem was how to pay for this huge deficit. As long as global financial institutions were flush with cash they were happy to lend to Turkey. Now that the Euro is close to implosion these same financial institutions have become much more careful where they put their funds. Not good news for Turkey. Then Europe, the major destination for Turkish exports, embarked on aggressive austerity programs with the obvious effect of consumers slowing down their purchases of those nice Turkish – assembled televisions or refrigerators.

Spooked in part by the exploding Current Account deficit investors began to shed the Turkish Lira. It’s 20% decline so far this year makes it one of the worst performing currencies in the world. The Istanbul Stock Exchange has also been in a free fall this year, down more than 30% in US dollar terms.

A common Central Bank response to rapid consumption growth and depreciating currency is to increase interest rates. Stuck with the government’s rigid zero interest rate philosophy the Central Bank has been unable to take this step. This is where the contortions come in. The official Central Bank interest rate remains at 5.75%. However, there are few, if any, transactions at this price. If a commercial bank needs to borrow from the Central Bank it will pay more than 12%. Commercial banks, under no philosophical constraints, have been quick to ratchet up their loan rates.

None of this is good news for an economy that needs hundreds of millions of dollars in external funding every year just as the sources of that funding are drying up. The sooner government officials acknowledge this trend, the chances the Turkish economy avoiding a major train wreck improve greatly.

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