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    Two critical mistakes played a key role

    Fatih Özatay, PhD05 September 2013 - Okunma Sayısı: 1102

    Since the late 2010 up to today, the interest rate policy of the CB relied mainly on the exchange rate movements.

    No, we are not ruined or anything. True, interest and exchange rates will be higher and 4 percent growth for the next couple of years will burst us with happiness. But don’t worry, to save us from the trouble of bursting, growth rate will most probably settle at a considerably lower level. Meanwhile, unemployment rate will get stuck at 10 percent. The level of investments will decrease, year-end inflation rate will float around 8 percent. It will probably be slightly higher in 2014. Yes, this scenario is a bit pessimistic, but it will not be disastrous. Of course, these hold under the assumption that Turkey will not get involved in Syria further.

    We would not have to think about these pessimistic scenarios if conditions were different: Turkey’s savings rate is radically low and decreasing. The level of investments was not adjusted to that of savings. Otherwise, the already low investment to GDP ratio would have been even lower, affecting the GDP growth performance negatively. The Federal Reserve (FED) generously injected liquidity to the system and the money looked for high returns in emerging markets. Turkey wanted to profit from this trend. But now that phase is over. Fund inflows now will be remarkably lower, let alone the funds that will escape when they have the chance.

    There was another option, however. Turkey could have prevented savings to fall to radically low levels by implementing an economic policy that restraints consumption growth. Note that I do not talk about structural reforms that promote long-term savings. Rather I focus on short-term policy options. Anyway, this was not done. Two critical economic policy mistakes were made instead, both of which prevented an ease-down in consumption: 

    The Central Bank (CB) succinctly identified by the end of 2010 that the economy gained too much speed. Rapid growth meant high current account deficit and high foreign fund requirement. To prevent this, the CB decided to decrease domestic credit growth rate. This too, was the correct approach.

    Nevertheless, the policy it implemented between October 2010 and June 2011 did not serve the purpose, since the Bank assumed that it could lower credit growth simply by raising the required reserve ratios. Or it had to since the authority which had the means to accomplish this target did not step up. I don’t know about that. But I have said numerous times here that the policy would not work. And so it did. Credit growth rate did not ease down during the first half of 2011. Time was wasted. The Banking Regulation and Supervision Agency (BRSA) stepped up only by the mid-2011 after the general elections and introduced a series of measures. I don’t know either what the role of the general elections was in the delay of eight months in BRSA’s taking action. Yet, it is clear that this was a critical policy mistake, although the diagnosis was successful. At the end of the day, Turkey had the highest current account deficit of all times.

    The second mistake came from the CB. Since the late 2010 up to today, the interest rate policy of the CB relied mainly on the exchange rate movements, such that from time to time deposit and bond interests remained below inflation for long periods. This triggered consumption, which either pushed up or prevented the slowdown of current account deficit.

    The right thing to do was that the BRSA alone would undertake the entire task of preventing rapid credit growth while the CB would concentrate on inflation, and cut interest rates as lira appreciates (exchange rate decreases), which would automatically cut down inflation. It should have cut the rates after, not before the inflation eased down. Because otherwise, to give way to what you were trying to prevent in the first place: interest rate falls below inflation rate, consumption is triggered, savings are discouraged, current account deficit is pushed up since investments remain constant, short-term fund inflows accelerate, exchange rate decreases, and in the end you have to cut back interest rates further…

    This commentary was published in Radikal daily on 05.09.2013

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