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Caution for the next three years
The FED will evidently clear away the lump as soon as growth and employment figures reach desired levels.
If people give up the conspiracy theories and try to understand what is actually going on, they will realize that important economic risks will be facing Turkey in the next three years. Evidently, chief among these is that the Federal Reserve (FED) withdraws liquidity it has generously injected over three quantitative easing programs. During this process, US interest rates will increase considerably.
Mind you, the cause of turmoil in emerging market economies in the recent weeks was not that the FED announced it has or is going to initiate the withdrawal process. Rather, it declared that it will gradually reverse quantitative easing it has carried out by purchasing bond and mortgage backed securities since fall 2012. Besides, it did not declare that the withdrawal will be initiated right away.
Since 2007, the balance sheet of the FED has growth extraordinarily. Currently the monetary base of the US is 3.8 times bigger compared to that at the end of 2007. The FED will evidently clear away the lump as soon as growth and employment figures reach desired levels. In other words, what shook the world lately is not that injections that make slight additions to the lump will be ceased. The main issue here is that clearing away of the lump per se.
True, the withdrawal will be gradual, but the overall magnitude to be withdrawn is astonishing. This is true even if we assume that the excess liquidity will not be withdrawn entirely, since this is the main source of the short-term capital inflows to Turkey and similar countries. Since we did not witness before a withdrawal at this degree, we cannot precisely estimate the consequences.
Yet, we have clues concerning past experiences. In the recent past, there are two periods when financial markets went into turmoil due to the possibility of a monetary tightening to be introduced by FED. The first was in 2004. I have recently reviewed the effects on Turkey here at this column: exchange rate and interest rate increased sharply in one or two month’s time. It all went back to normal in three to four months. It did not have an effect on growth and unemployment. Most likely it was partly because the Central Bank did not raise its policy rate but waited for the markets to calm down. Indeed, in 2004 and 2005, Turkey enjoyed high growth.
There would be no reason to worry if we were confident that growth would not be unaffected and unemployment would not increase again this time. But the developments faced in 2006 are alerting: exchange rate increased more sharply compared to 2004. But interest rate movements were even more alarming. Though the rate of increase was slightly above that in 2004, the outlook did not go back to normal. The rate did not go back to the old level from May 2006 when the upwards movement started to the end of 2007. The Central Bank increased the policy rate from 13.25 in May 2006 to 17.5 in a month and half. The rate stood at this level until September 2007. Partly due to this increase, growth rate decreased to 4.7 percent in 2007. The rate for 2008 was as low as 0.8 percent. Indeed, per capita income growth was negative. In 2004 and 2005, growth rates were above 8 percent.
If I were in the shoes of the economic management, I would scrutinize the developments in 2006. Why was Turkey affected more severely in 2006? Interest rate raises cannot be the only reason I guess. For starters, current account deficit in 2006 was substantially high compared to 2004 – indeed it was the highest level so far back then. How did net capital inflows evolve? Which sector first faced difficulty in repayment? Were fiscal policy decisions correct?
This commentary was published in Radikal daily on 02.07.2013