You only die once. The danger of this policy is that it might temporarily erode Turkey’s competitiveness.

Low interest rate policy and generous liquidity injections of developed countries put developing countries including Turkey into big trouble. Turkey also has a special condition: it was upgraded to investment level by two different rating agencies, Fitch and Moody’s, which accelerated foreign fund inflows. This movement might be reversed on two conditions: first, if a crisis similar to that in Cyprus is recurs in Europe, fund inflows come to a halt. In fact, such a development might even lead to a net capital outflow. Fund inflows might be affected negatively also if the turmoil in Syria increasingly bounces to Turkey’s territories.

Without these, fund inflows accelerate, putting an upwards pressure on the lira’s value. In addition, inflows trigger credit growth, but I will set this one aside. The Central Bank does not want the lira to appreciate in real terms. Moreover, the fluctuations in fund inflows cause exchange rate volatilities, which is another consequence the Central Bank wants to avoid. The Bank therefore has been cutting its policy rate for some time now. Also, it recently has assumed a liquidity policy which allows the short-term interest rate on interbank transactions (that is, the market interest rate) to be lower than the policy rate. As a consequence, deposit rates and Treasury bond rates are currently lower than inflation.

In my previous commentary I said that I found this policy risky. Here is why: to begin with, the policy minimizes the exchange rate uncertainty, making the return on foreign investments calculable almost accurately. The policy which aims to overcome the negative consequences of fund inflows in turn accelerates inflows further. Second, the policy reduces domestic savings as much as it allows interest rate to fall below inflation. Besides, it has the potential to shift existing savings to economically undesired investment instruments such as gold. Turkey’s domestic savings rate is already low and has to be improved.

Policy alternatives

What are the policy alternatives? The first one that comes to mind is introducing capital controls that discourage short-term fund inflows. I know that the government has several times announced that this path will not be taken. What might be other alternatives?

To focus on headline inflation, maintain the policy rate until headline inflation tends down, allow the lira to appreciate, wait for the appreciation to lower headline inflation and then cut the policy rate, and meanwhile make sure that deposit rates do not fall below the inflation rate. Of course, the government must not introduce one-time tax raises that push inflation up meanwhile.

You only die once. The danger of this policy is that it might temporarily erode Turkey’s competitiveness. The keyword here is temporarily. What is more, the cost of the policy will be lower if energy prices help inflation rate to ease, as it is the case currently. If the current policy is maintained, however, the “patient” will need intensive care for some more time. In addition, in the absence of a policy to lower inflation, production costs remain higher in Turkey than in its rivals.

This commentary was published in Radikal daily on 21.05.2013