Complacency Means Fewer Counter-Cyclical Options
BMI View: Policy complacency over recent quarters has severely curtailed Turkey's ability to enact counter-cyclical policies in the face of weaker domestic and external demand. While the authorities have sufficient ammunition to prevent an economic crisis, failure to act during the good times has heightened the risk of prolonged damage to the country's investment profile.
Expectations of promotion to investment grade status and the global hunt for yield saw Turkish policymakers lose sight of the need for economic rebalancing in recent quarters, and over the past month this complacency has been heavily punished by investors. The country's excessive reliance on external financing, combined with heightened levels of public protests against the governing Justice and Development Party (AKP), saw Turkish assets hit harder than most other emerging market (EM) peers in the recent financial market rout. Since we believe EM as an asset class is set for a prolonged period of weakness, the Turkish authorities face a major challenge in restoring confidence against the backdrop of dwindling credibility for key economic and political institutions.
Limitations of Monetary Policy
In Q113 we argued that loose monetary policy was threatening the credibility of Turkey's central bank (CBRT), since it was prioritising short-term growth over inflation-targeting and financial sector stability ( see 'Central Bank Credibility At Risk', March 13). These warnings may have seemed alarmist after Turkey's formal elevation to investment-grade status in May this year, but the rout of Turkish assets since then has reinforced our view that recent monetary policy trajectory has eroded financial stability. That does not mean that monetary policy has become completely redundant, as there is room for the CBRT to adjust its overnight lending rate while keeping the repo and borrowing rates on hold, which could ease domestic interbank liquidity conditions without prompting further FX weakness.
|Still Room To Narrow|
|Turkey- Spread Between O/N Lending and Borrowing Rates, pp|
However, by not clamping down on rampant credit growth and the level of net FX liabilities among domestic corporates, the CBRT has severely limited its ability to boost lending in the face of slower economic growth. With the aggregate loan-to-deposit ratio for the banking sector now above 1.0, access to external financing increasingly restricted, and loan quality at risk from the recent lira selloff, domestic banks look either unwilling or unable to ramp up the supply of credit, regardless of whether the CBRT can bring down interbank liquidity. We also have serious doubts about demand for credit, given the likely impact of recent political unrest on consumer and corporate sentiment. In other words, the CBRT now has limited ability to implement counter-cyclical policy, with its role largely limited to crisis management.
Government Not Much Better Positioned
A low public sector debt burden (less than 40% of GDP) and relatively healthy fiscal accounts mean the Turkish government has greater leeway to implement counter-cyclical policy than the central bank. There is also significant incentive for Prime Minister Recep Tayyip Erdogan to pursue populist fiscal policies following the damage done to his reputation by the recent protests ( see, 'Protests Tarnish Erdogan's Domestic and Regional Clout', June 13). However, the government's room for manoeuvre has been diminished in recent months, in terms of both ability to raise capital and ability to spend it. On the financing side, the recent blow out in the government's borrowing costs and reduced investor demand for EM debt in general will make resorting to fresh debt issuance much less attractive. Potential revenue from the government's privatisation agenda will also be capped by the spike in developed state yields, which will translate into a higher cost of capital for external investors, thereby reducing the amount they are willing to pay for state-owned assets.
|Disincentive To Borrow More|
|Turkey - TRY 9.5% 2022 Sovereign Bond Yield, %|
In terms of ability to boost expenditure the government's options have also been limited by the failure to rein in Turkey's gaping current account shortfall, as any attempt to support household expenditure would reinforce the lack of domestic productivity and increase the reliance on external financing. This implies that if the government does pursue fiscal stimulus it should focus more on capital rather than current expenditure. However, a policy of direct public sector investment is also not without problems, since this could jeopardise the government's privatisation agenda while at the same time hurting Turkey's longer-term growth potential by increasing the government's footprint in the economy (which in our view would overshadow any potential gains from closing the infrastructure deficit).
|Turkey - Current Account Balance, US$mn|
One way in which the government could avoid direct public sector investment is through off-balance sheet financing, such as subsidised credit through a state development bank. Although this policy is yet to be tried in Turkey, it has been widely used in other EM economies such as Brazil and Russia, and in Brazil's case it has helped spur significant investment into infrastructure. However, in our view the long-term fiscal and growth impact of such policies would be broadly the same as direct government investment, since it incentivises investment into unprofitable projects, lowering the country's long-term rate of growth and future fiscal revenue. Therefore, while Turkey's government perhaps has greater capacity to increase expenditure and leverage than many other EM peers, any significant fiscal stimulus would likely have a detrimental impact on the country's longer-term investment story.