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    Does the CB need an alternative policy?

    Fatih Özatay, PhD18 May 2013 - Okunma Sayısı: 863

    A second rating agency upgrading Turkey’s rating is a positive development concerning both the cost and volume of borrowing.

    Two positive developments we heard this week: Turkey paid off its debt to the IMF and Moody’s upgraded Turkey to the investment grade. Following Fitch, a second rating agency upgrading Turkey’s rating is a positive development concerning both the cost and volume of borrowing. Developed countries carry on with the low interest rate policies and quantitative easing. Latest, Japan joined the team. Over the last months, Turkey enjoyed high volumes of foreign capital inflow. The rating upgrade implies that inflows might accelerate in the period ahead, provided that the international risk appetite is not reversed.

    This story makes things more difficult for the Central Bank. There are two underlying factors, which are at the same time the reasons why Turkey has not yet completely achieved macroeconomic stability: domestic savings rate is radically low and the corporate sector has a high stock of FX debt. Foreign fund inflows put a downwards pressure on exchange rate. The Central Bank is of the view that this erodes Turkey’s competitiveness and therefore aims to keep the exchange rate at a level that prevents both appreciation and depreciation of the lira in real terms. It also seeks to prevent fluctuations around this level by constantly reducing interest rates. I have emphasized a number of times lately that I find this policy risky. Please note that I don’t argue that the policy is vacuous or completely mistaken. On the contrary, it is one of the options. But I don’t think it is the best one available.

    Let me remind you of the risk once again: if the level of exchange rate becomes foreseeable, foreign fund inflows will be encouraged. Interest rates in Turkey are still higher than developed countries no matter how much the Central Bank cuts it. In that case, the main factor that determines the return of foreign investment is the exchange rate when they enter and leave the market. They know the first, they don’t know the second. The policy in effect, however, minimizes the uncertainty and makes the level of return calculable almost accurately. Hence, the policy aimed to overcome the negative consequences of fund inflows in turn cause fund inflows to accelerate further. Moreover, the policy reduces domestic savings as much as it allows interest rate to fall below inflation and it has the potential to shift existing savings to economically undesired investment instruments such as gold. This implies that Turkey will need higher fund inflows in order to achieve a given growth rate. Of course, the extremely low level of interest rates in the rest of the world and the ongoing interest rate cuts are valid counter arguments. This might suggest that the current policy is inevitable at least for the time being. But please note that Turkey’s savings rate is already low and counting down. And we have a high current account deficit: when Turkey’s growth rate was 2.2%, its current account deficit was as high as 6% in proportion to the GDP. Hence, the deal here is different. So, what are the alternatives? I will address one of them on Tuesday if the agenda allows.

    This commentary was published in Radikal daily on 18.05.2013