Acting Like A Strategist (September MPC preview)

Maintaining financial stability will clearly remain at the heart of the CBT’s policy agenda, in our view, at the forthcoming MPC meeting on Tuesday, September 17. As such, the rhetoric to be employed by the MPC at this ninth meeting of the year, and potential resolutions, will likely amount to a stamp of approval for the stance recently adopted by the CBT. Hence, the meeting should largely prove a non-event for markets. The only measure we would expect out of the September MPC meeting is a change in mechanisms for FX liquidity provision, as flagged during the Ankara meeting.

In a scenario featuring capital outflows, possible reactions by the monetary authority in the framework of ROM mechanism -- in a bid to play a balancing role in terms of FX liquidity -- are provided below. Considering the prevailing state of affairs, option (b) appears to us as the most viable course of action:  

(a) The CBT reduces the ROC, and FX reserves kept by the banks with the CBT decline. As a result, FX supply in the market increases; TRL liquidity remains constant; and the intervention is aimed more at the volatility -- rather than the level -- of the TRL. This is similar to a sterilised FX intervention. As regards monetary stance and credits, it would correspond to an easing.  

(b) As an alternative to a change in ROC, the reserve option rate may be reduced. In such a situation, because the FX reserves banks may keep with the CBT would decrease, this would foster FX supply in the market. On the other hand, TRL liquidity would tighten and the deprecation of the TRL would be limited. This may be considered as a mechanism comparable with a non-sterilised FX intervention, which is aimed more at the level -- rather than the volatility -- of the TRL. As regards monetary stance and credits, it would amount to a tightening.  

(c) The CBT cuts the FX RRR, and FX reserves kept by the banks with the CBT decline. As a result, FX supply in the market increases; TRL liquidity remains constant; and the intervention is aimed more at the volatility -- rather than the level -- of the TRL. This is similar to a sterilised FX sale intervention. As regards monetary stance and credits, it would correspond to an easing.

August MPC Meeting: Door left open for further monetary tightening… At the previous meeting, the CBT had hiked the upper band of the interest rate corridor by 50bp to 7.75%, while leaving the lower band and the policy rate stable at 3.5% and 4.5%, respectively. However, the interest rate on borrowing facilities provided to primary dealers was kept unchanged at 6.75%. In other words, the CBT continued to provide funding to primary dealers at 6.75% on “normal” days, but the funding rate would increase to as high as 7.75% on “exceptional” days. In the statement, the CBT left the door open for further monetary tightening by reiterating the following: i) “cautious stance will be maintained until inflation outlook is in line with medium-term targets”; ii) “additional monetary tightening will be implemented when necessary”.

Currency tumbles: CBT changes tactics… As the TRL came under major selling pressure and bond yields soared in the aftermath of the MPC meeting, Governor Basci held a press briefing, where he unveiled the new monetary stance, along with a shot of verbal intervention in FX (pronounced year-end US$/TRL level as 1.92). The new stance envisages eliminating the “uncertainty in interest rates” i.e. the CBT will implement a predictable monetary policy, which is expected to foster interest rate stability. As we already know, this implies that all rates (policy and corridor) will remain stable until further notice, and cost of CBT funding may vary within a range of 6.75 – 7.75%.

Principal objective: to mitigate sensitivity of TRL interest rates to global rates -- The monetary authority sought to achieve this via breaking the negative feedback loop between rate hike expectations and domestic currency depreciation. By doing so, the CBT tried to insulate domestic markets from volatility generated by data surprises driven by Fed tapering. In the presentations published after this communication, the CBT described this strategy as follows: “Predictability of Turkish lira liquidity policies are increased, while dependence on high frequency data is eliminated.” As we had commented earlier, the main aim is to attract interest in local bonds by fixing the funding rate, and we think the short-end of the bond yield curve would benefit the most from this stance.

However, the flipside of this policy would inevitably be higher FX volatility, which means continued depreciation pressure on the TRL, at least until the Fed provides clear policy messages. Since the CBT will not use the interest rate weapon against the exchange rate, this strategy requires additional instruments providing FX and LC liquidity. Since we surmise there are no new tools (swap, option or forward) to defend the TRL, CBT officials pinpointed the Bank’s FX reserves as a main defence mechanism. According to Deputy Governor Kenc, the CBT could use not only net FX reserves (US$40bn), but also most of the gross FX reserves (FX ROM US$32.1bn and FX RRR US$28.1bn) if need be. In that regard, first of all the CBT will continue to inject liquidity through daily FX selling auctions and be “offensive”. Moreover, CBT officials suggested that FX liquidity would be provided from gross reserves via ROM and FX required reserves, if needed.

In fact, the CBT expects the TRL and LC interest rates to adjust -- on the back of greater interest on the part of foreign investors in local bonds -- after having overshot initially. This expectation is discernible also from the recent presentation (Governor Basci’s Presentation at OMFIF Meeting on "The Role of Emerging Market Economies in Building World Prosperity"); i.e. sections devoted to bond yields and REER. Regarding yields, Governor Basci described the current situation as an “overreaction”, voicing his expectation for “mean reversion”, which implies around 100-125bp fall in 3m and 2y yields from the levels observed on September 2.

Betting on mean reversion: viable, yet risky… The “overreaction” message for the TRL was communicated through the projected level of the Real Effective Exchange Rate (REER) Index, and a new lower bound was added to stress the undervaluation of the TRL. We already knew that the CBT had drawn a red line for the TRL’s overvaluation, referring to the trend line of 2% annual appreciation that starts with the index base (May 2003=100) and reaches around 120 level this year. This has been considered an upper bound for the REER throughout the year. Conversely, the new line sets a lower bound for the “fair” value of the REER, drawn by starting from the initial value (Jan 2003=90) of that index and with the same appreciation trend. Based on the CBT’s calculations, September REER may dip far below the new line, assuming the exchange rates (FX basket 2.38 against TRL) prevailing at the early days of September being sustained throughout the month. The graph denotes the CBT’s expectations for mean reversion in an uncertain timeframe. We believe the now famous 1.92 level for the US$/TRL is a product of this exercise. Nevertheless, at the Ankara CBT-Investor meeting, Deputy Governor Kenc sought to downplay the significance of this parity, claiming this was merely an example to underline the fact that EM currencies typically appreciate after underperforming, and this is bound to happen to the TRL as well in an uncertain timeframe.

In our understanding, the CBT is first introducing a shock to trigger an overshoot in the FX market, and then betting on mean reversion. We continue to view this as a feasible, albeit risky strategy, predicated apparently on the assumption of a possible relief to follow the resolution of the Fed policy uncertainty with the September 17-18 meeting. 

Taper the fearing. Don’t fear the tapering.

A hectic month for markets; but correction in the cards in the short term -- Benchmark and 10-year TRL-denominated bond yields have jumped almost 300bp from their historic lows of 4.61% and 5.97%, respectively, as of the date of Turkey’s sovereign rating upgrade to investment grade (IG). In the meantime, the TRL has weakened 8% and Turkey’s CDS premium has almost doubled to 230bp, while the stock market has shed 24% from its peak. Though profit taking was not quite unexpected for Turkish assets after the upgrade to IG by Moody’s, its magnitude has exceeded our projections, driven by uncertainties posed by FED tapering. On the other hand, TRL assets have underperformed EM peers to some extent, probably related to re-pricing of political risks after incidents during Gezi Park protests, though an optimist may also perceive this as a correction after the significant outperformance preceding the IG upgrade. Whatever the reason, the damage is done… Yet, it is still not clear whether the Fed’s base case scenario (The Federal Reserve may “moderate” its pace of bond purchases later this year and may end them around mid-2014) will pan out, as this seems contingent on sustained improvements in non-farm payroll and economic activity. Therefore, we deem Fed fears overblown and perceive the 100bp spike in US10YT in such a short period of time exaggerated. From a different perspective, however, pricing in of tapering fears sooner rather than later may bode well for risk sentiment, going forward. On the other hand, even though tapering off of QE on a flow basis seems quite imminent in a likely scenario, monetary tightening i.e. Fed funds rate hike, potentially lies further ahead and seems unlikely before 2015. 

Sell in May… Well, if not, in June… The timing of the significant capital outflows from EMs and Turkey is quite consistent with the seasonality of global fund flows, reminiscent of the old adage “Sell in May and Go Away”… But the sell-off has intensified and continued after the June FOMC meeting, which may rekindle “sudden stop” concerns. We think, however, that drawing definitive inferences would be premature at this stage, and further observations seem necessary. Investors might recall that cumulative capital outflows in May via different channels reached US$7.9bn -- mainly through swap transactions (US$6.6bn) -- while the bulk of the outflows occurred prior to the domestic disturbances. However, US$2.7bn had already returned in the first two weeks of June. As usual, the shift in the direction of capital flows triggered an immediate change in the CBT’s monetary stance, from easing to tightening, albeit in gradual steps. Apart from that, we believe an improving outlook for economic activity and a likely deterioration in inflation due to exchange rate pass-through also underpin the case for a tighter stance. Considering that the CBT’s recent policy framework is focussed entirely on weakening the tight link between capital flows and domestic economic indicators such as loans and the current account deficit, we might assume that the direction of capital flows will also be vital for monetary policy decisions, going forward.

Global and local growth on the right track, if you are looking backwards... Taking a glance at the current state of affairs, the slide in PMI indices since February -- the most widely followed leading indicators of global economic activity -- has ceased in May, possibly signalling an end to loss of momentum in global recovery. In the case of Turkey, GDP growth beat expectations with 3% yoy increase in 1Q13, and latest IP data, as well as other leading indicators including capacity utilisation and real sector confidence indices, suggest a further acceleration in economic activity in 2Q13. While these had initially raised the odds for the achievement of our 4% 2013 GDP growth forecast, the turmoil in global markets and on-going re-pricing of domestic political risks ahead of the heavy election agenda have jeopardised our GDP growth forecast via hurting consumer confidence; prompting monetary tightening; and entailing tighter financial conditions. Nevertheless, the fact that such developments impact growth expectations for the year 2013 only to a limited degree is apparent from the minor retreat in average growth expectations -- from 4.1% to 3.9%, at least for the time being. On the other hand, despite the significant rise in the trade deficit in April -- and probably in May -- due to surprisingly high gold imports, downside risks to growth in second half and the continuation of the downward trend in prices of commodities, most notably oil, may suffice to infer that the deterioration anticipated in the current account balance in 2013 should be contained. Meanwhile, year-end inflation expectations have deteriorated slightly in June survey to marginally above 6.5%, while 12- and 24-month forward looking inflation expectations have remained close to 6% levels. However, considering a probable jump in annual CPI in June due to unprocessed food prices and the likely FX pass-through (10-15%) to prices if the 8% weakening of the TRL is sustained, not to mention administrative price increases, the extent of the deterioration in inflation expectations would be the most important factor to be monitored by the CBT regarding monetary policy decisions. All in all, considering all the factors mentioned above, we have made some revisions to our macro and financial forecasts, which are provided in this report.

Last but not least, we believe the fate of Turkish assets is closely tied to global risk appetite i.e. fluctuations in US Treasury yields, in the very short term. Following drastic price gyrations, we would expect domestic markets to meander in consolidation ranges in the short term, with intermittent relief rallies. Technically speaking, the stock market may settle in a range of 70,000-78,000 if the BIST holds above the 73,000 level. Regarding the secondary bond market, where the “Great Bond Massacre” took place, we still attach less likelihood to interest rates closing the year above current levels. On the FX front, it is clear that the TRL will remain under pressure amid capital outflows. If this is not idiosyncratic, the CBT may only smooth the process with the tools at its disposal and try to eliminate the underperformance against the EM average, which is exactly what it has been doing. During such periods, it is hard to draw a line in the sand, i.e. defend a certain level with full force. It seems sensible, rather, to try to avert any excessive depreciation pressure on the domestic currency, via orderly FX selling auctions. In our view, the CBT, mindful of the inflationary risks posed by the recent depreciation of the currency, may take measures including an interest rate corridor hike, if need be, in order to bring the TRL against the FX basket within the implicit comfort zone (2.05 - 2.20) for 2013.

May MPC Preview - Take It Easy...

The fifth Monetary Policy Committee (MPC) meeting of 2013 will be held on Thursday, May 16. Following Bank of Japan’s (BOJ) unprecedented quantitative easing decision dated April 4, many central banks -- including the ECB -- followed suit, easing their monetary stance further. As expected, this prompted a re-acceleration of capital inflows (cumulative inflows via different channels reached US$10.6bn), validating the CBT’s bid to safeguard financial stability. Moreover, the benign CPI reading of April and disappointing March IP data, indicating still below-potential growth, have strengthened the case for lower rates. Therefore, the CBT is likely to reiterate at the upcoming MPC meeting once again the ingredients of its optimal policy recipe; i.e. accommodating the global low interest rate environment, while increasing foreign currency reserves via macroprudential measures. 

The current monetary stance implies, in our view, that the CBT leaves the door wide open for more rate cuts. Thus, we think a 25bp cut to the policy rate and a 50bp cut to the interest rate corridor seem in the cards for this meeting. On the other hand, in a bid to intensify the sterilisation of capital inflows, a gradual rise in FX and gold ROCs should also be expected. According to the Reuters survey held ahead of the MPC meeting, consensus expectations are skewed towards a 50bp cut for all rates. Out of the 11 economists canvassed, 8 are expecting a 50bp cut to the interest rate corridor this month, while 7 are in anticipation of a 50bp cut to the policy rate, accompanied by a further increase in ROCs and no change in RRs.

Meanwhile, the consistency of the evolution of intermediate variables (loan growth, REER and inflation expectations) of monetary policy with targets (price & financial stability) should remain paramount in the decision-making process. In this framework, at the last Inflation Report, the CBT said “…bringing inflation close to the target without deterioration in external balance requires that credit should be growing at a reasonable rate, while domestic currency should not be appreciating excessively.” However, the CBT does not sound perturbed about above-reference loan growth; rather, it seems the monetary authority continues to overlook the recent strength in loan growth, at least until GDP growth reaches its potential. On the other hand, in response to questions on the real effective exchange rate (REER), Governor Basci stated that the REER was above the 120 threshold during the April MPC meeting, and their decisions at the next meeting would hinge on where the REER lay by then. Indeed, the REER rose to 121.1 in April, from 120.3 in March, according to data released by the CBT. Note that the CBT had already reacted to the above-threshold reading by cutting both the policy rate and the interest rate corridor by 50bp at the April MPC meeting.

However, the TRL has hardly responded to the CBT’s move since then, and continues to trade at around 2.07 against the currency basket (0.5$+0.5€). If the TRL remains below 2.09 levels through the remainder of the month, the REER is likely to overshoot the 120 mark in May as well.

It is also worth noting that following the BOJ’s move, another wave of policy rate cuts by emerging market (EM) central banks has ensued. The average policy rate of selected EM countries -- that is closely monitored by the CBT as well -- has dipped below 4.5% recently. The CBT may seize this opportunity once again to eliminate the prevailing difference in interest rates.

Last but not least, the CBT recently abandoned its active liquidity management policy and stepped up liquidity provision. Consequently, short-term repo and swap rates fell sharply and converged to the borrowing rate. Liquidity provision in excess of the banking system’s needs reinforce our belief that the CBT is contemplating also a borrowing rate cut in order to avert hot money inflows. However, TRL RR need has increased visibly since last Friday. This might suggest that the banks had already lowered their ROM utilisation for certain tranches of ROC; thus, their TRL need increased proportionally. This also may explain the increase in S/T swap rates to more normal levels since Friday. All of these developments possibly imply that the CBT may consider keeping ROC unchanged and become less aggressive on rate decisions, which appears consistent with our call for a 25bp cut to the policy rate.  

Capitalising on Global Trends…

The state of indecisiveness that characterised market sentiment in the early months of the year has given way to drastic changes in pricing as of the end of the first quarter. Apprehensions as to the strength of global recovery and Bank of Japan’s unprecedented quantitative easing decision have set the stage for dramatic declines primarily in commodity prices and long-term bond yields. This, on the other hand, sets an extremely supportive backdrop for Turkey’s economy and financial markets. Continuation of easy global liquidity conditions -- at a low cost -- and not leading to a bubble in asset prices is probably a dream scenario from Turkey’s perspective.

It appears that sub-potential growth once again in the first quarter and a downward course in commodity prices, most notably oil, will lead the deterioration in Turkey’s foreign trade and current account balances -- triggered by the recovery in domestic demand -- to be contained. It seems to us that the most recent decisions by the CBT are intended entirely “to weaken the link between capital flows and domestic macroeconomic variables such as credit and current account deficit”, and that the monetary authority has been relieved of the pressure from rate cut expectations, thanks also to a supportive global backdrop. We continue to believe that this general outlook reinforces credit rating upgrade expectations, potentially allowing agencies other than Fitch the opportunity to raise Turkey to investment-grade category.

Looking at the current state of affairs, the principal leading indicator, PMI indices, have continued to drift lower in March on a global scale, following the retreat in February, which attests to the slowdown in global recovery. As for the Turkish economy, growth in 1Q13, albeit definitely above the previous quarter, will nonetheless continue to undershoot potential growth rate. We did acknowledge that these developments could somewhat weigh on 2013 growth perceptions, though it is noteworthy that expectations still remain unchanged at 4.2% levels, based on survey findings. Despite a minor increase in YE13 inflation expectations towards 6.6%, 12- and 24-month forward looking inflation expectations remain closer to 6.0%. Nevertheless, considering the appreciation pressure on the TRL and sliding commodity prices, a deterioration in inflation expectations appears quite unlikely, in our view. Finally, these developments warrant minor changes to our forecasts, which we also provide in this report.

As for markets, we attach significant likelihood to a retest of earlier record highs for the BIST in the short term, buoyed by Moody’s rate hike expectations. Even in the event that expectations are fulfilled, however, we see it likelier for the market to switch to more of a range-bound trading pattern. Regarding interest rates, intervention by the Bank of Japan and actions by the CBT -- keen not to miss this opportunity -- have created a drastic change in outlook. While we continue to expect interest rates to follow an upward slope until the year end, compared to our earlier forecasts, we now expect increases to be more gradual and limited in magnitude. On the exchange rates front, given renewed intent by the CBT to take all measures necessary to surmount any pressure from capital flows, we continue to expect the currency basket to fluctuate within a band of 2.05 - 2.15 throughout the year, and not to dip below the 2.05 mark.

MPC Preview - All Roads Lead To Rome

The fourth Monetary Policy Committee (MPC) meeting of 2013 will be held on Tuesday, April 16. We perceive Bank of Japan’s (BOJ) unprecedented quantitative easing decision dated April 4 as a major “game changer”. This should also help alleviate uncertainties posed by the direction of capital movements, regarding which the most recent MPC meeting statement included the following prediction: “The Committee foresees that tighter liquidity policy along with weaker capital inflows will slow down credit growth”. Yet, the ensuing meeting minutes included the following statement, leaving the door open for the monetary authority to act in the event that the opposite case prevailed: “Necessary measures will be taken through liquidity policy, ROM, and reserve requirements should capital inflows re-accelerate”. In short, we expect the CBT to revert to its commonly known base scenario and to reiterate its following stance: “In order to contain the risks on financial stability due to strong capital inflows, the proper policy would be to keep interest rates at low levels while continuing with macroprudential measures”. To this end, we attach significant likelihood to a 50bp cut to both the policy rate and the interest rate corridor. Additionally, more dramatic increases in FX and TRL reserve requirements compared to early practices (50bp and 25bp), in a bid to intensify the sterilisation of capital inflows, could be expected, in our view. Such a move, on the other hand, would reduce the possibility of a new increase in reserve option coefficients (ROCs). Our forecasts are predicated on the assumption of a somewhat more aggressive stance by the CBT regarding interest rates and macroprudential measures compared to the consensus view.

In the early days of the month in progress, at a speech in Mardin, CBT Governor said a measured cut to the policy rate may come on the agenda should the REER top the 120 threshold. Indeed, according to our calculations, the REER is likely to exceed the 120 mark significantly in April if the TRL continues to trade at current levels (2.06) against the FX basket. Moreover, additional quantitative easing decisions by developed countries set the stage for policy rate cuts by emerging market (EM) central banks. The average policy rate of ten EMs -- that are closely monitored by the CBT as well -- has retreated to 5% levels at this point. The CBT, keen to maintain its relative position and to mitigate the appreciation pressure on the TRL, may seize this opportunity to eliminate the prevailing difference in interest rates.

However, the CBT would run the danger of being perceived to have apprehensions about growth, and using the REER as a pretext to deliver a policy rate cut, especially if such as decision is not counterbalanced by macroprudential measures. Therefore, the way the monetary authority chooses to communicate these decisions will be more important than ever to contain potential loss of credibility.

Investors might also recall that the CBT had withdrawn excess liquidity a few days before the March MPC meeting and embarked on active liquidity management thereafter; thus, repo rates had risen significantly. However, repo rates have started to fall sharply over the last few days, which could be considered as a probable end to liquidity squeeze ahead of the April MPC meeting. This might also imply that a borrowing rate cut will accompany a policy rate cut at this meeting, to ease the appreciation pressure on the TRL.

Ground Control to Major Tom…

The month of February will probably be viewed, in retrospect, as a time when the somewhat excessive exuberance of the preceding months subsided and a sense of realism pervaded the market. But isn’t that generally the case anyway: hopes that turning the page to a new calendar year will usher in earth-shaking shifts give way, all of a sudden, to the realisation that economic trends do not change all that quickly. There is nothing disconcerting about that, though... It could even be considered a healthy correction, as it might pave the way for favourable market trends to be based on more solid foundations.
A similar pattern is already evident in global markets: the year started with expectations of an overall recovery, which promptly reflected on long-term bond prices, while stock exchange indices started testing 5-year highs... However, judging from the significant asset price gyrations, no decisive market trend seems in place for now. Regarding markets, news flow from the US will likely be of greatest significance in the short haul. While efforts in the US to find a lasting solution to the automatic spending cut slated to take effect on March 1, 2013 -- following a 2-month deferral as of the new year -- will be high on the agenda until the end of the month, opposing views within the FOMC as regards the FED’s open-ended asset purchases will also be keenly eyed.

As for the Turkish economy, we see no reason to alter our overall view of the year 2013, as fine-tuning in policy implementations will likely suffice in what seems to be essentially a year of safeguarding the gains. One key source of risk is for growth rate to fall substantially short of potential growth rate, as in 2012: such a development would be greeted with greater tolerance by the CBT -- intent to protect the improvement in external balances -- though a similar approach is not to be expected from the political administration. Such a situation would prompt limitations to the flexibility enjoyed by the CBT in terms of shifting its focus to different targets when necessary -- the predominant source of its effectiveness -- in the framework of its multi-instrument, multi-target monetary policy implementation. As we mentioned earlier, the CBT, which bases monetary policy communication on three intermediate variables (inflation expectations, loan growth and real exchange rate), has diverted its focus recently to more imminent risks such as acceleration in loan growth and appreciation pressure on the TRL, given a lack of threats from inflation expectations to medium-term inflation outlook.

From a short-term perspective, while 4Q12 growth data point to contraction in all key markets including the US, PMI indices -- a key leading indicator -- suggest global recovery will gain traction, bolstering hopes for the future. On the other hand, growth in Turkey has remained lacklustre in the last quarter -- confounding expectations -- and leading indicators for January do not quite support hopes of a recovery. Yet, this does not seem to affect growth perceptions for 2013, as the survey median remains unchanged at 4.2%. Moreover, although inflation has topped 7% in January with tax adjustments, deterioration in inflation expectations should be limited as long as volatility remains subdued in exchange rates and commodity prices. 

As for financial markets, our view expressed in our previous monthly report that the stock exchange index was in overbought territory was validated by the ensuing correction. In our view, selling pressure will persist for some time, subsequently leading to more of a range-bound bias. Regarding interest rates, on the other hand, the upward trend should continue, to be felt more on the long end of the curve. As for FX rates, given the CBT’s well-known stance and the framework drawn for real exchange rates, we continue to expect the TRL/currency basket not to fall below 2.05 and to fluctuate within a band of 2.05 - 2.15 through the course of 2013.

Three-way Betting

The second Monetary Policy Committee (MPC) meeting of 2013 will be held on Tuesday, February 19. While we will be providing our views as to potential decisions by the MPC at this meeting in the following paragraphs of this note, we first need to underline that the recent emphasis by the CBT on monetary policy decisions being “data-dependent” has increased the uncertainty compared to before, thereby raising the possibility of a surprise decision by the monetary authority. This is because data are objective, while analyses are subjective, and differences in interpretation among market players and the CBT might prove more substantive than ever.

Let us remind investors of key messages provided by the CBT at the January MPC meeting and the subsequent Inflation Report (IR): “Inflation forecasts assume that monetary policy decisions are data dependent. In other words, it is envisaged that credit and exchange rates follow a stable course and aggregate demand conditions are kept at levels that do not exert upside pressure on inflation. Accordingly, in response to incoming information regarding price stability and financial stability; short term interest rates, liquidity instruments, and macroprudential measures are set in a flexible and coordinated way. Therefore, the forecasts envisage an outlook where macro financial risks arising from the recent surge in capital inflows risks are contained. Forecasts are based on the assumption that annual loan growth rate will hover at around 15% and there will be no significant change in the real effective exchange rate. (…) Financial conditions index has continued to ease with rapid capital inflows, improving credit supply conditions, and accommodative liquidity policy. These developments point to the risk of further acceleration in credit and domestic demand for the forthcoming period, necessitating a cautious stance against macro financial risks. Therefore, in its first monthly meeting of 2013, the Committee highlighted the faster-than- expected credit growth and signalled that macroprudential measures might be continued should this trend persist.”

Under the light of these principal messages and despite the absence of any hints by the MPC at the January meeting, expectations of a “measured adjustment to the interest rate corridor” and continuation of RR hikes do seem reasonable, in our view, considering recent data flow and most notably changes in the real effective exchange rate (REER) -- a closely followed intermediate variable by the CBT -- and loans.

On the other hand, looking at the same data juxtaposed against the macro setting, and also considering Governor Basci’s remarks following the issuance of the IR, a wait-and-see approach by the MPC also seems somewhat plausible. Investors might recall that in the Q&A session of the IR meeting, Basci had stated that the measures taken so far on the RRR seemed sufficient to rein in loan growth at this stage, adding that the loan growth target was not too rigid. On the other hand, the REER had exceeded the “overvalued” threshold of 120 identified by the CBT in January, backing the monetary authority’s last action of a 25bp cut at the lower band of the interest rate corridor. Month-to-date in February, the REER continues to hover at about the January level, still within the CBT’s tolerance interval, as projected through 1.5-2.0% real appreciation annually. Based on our inflation forecast, the REER is likely to fluctuate at around the 120 mark in February, unless the TRL weakens to beyond 2.065 against the currency basket through the reminder of the month.

Finally, from today’s vantage point, neither the overshoot in inflation nor the undershoot in growth is expected to trigger a change in the CBT’s policy stance. Monetary policy is currently being shaped by the real performance of the TRL and the course of loan growth. Note that a cut at the lower band is aimed solely at deterring capital inflows, and is not expected to provide any additional stimulus to economic activity. Otherwise, we expect the CBT to maintain the policy rate at the current level.

Therefore, we think the following three courses of action lie before the CBT: i) Actions similar to January MPC meeting resolutions; i.e. shifting lower the interest rate corridor in a measured way, and implementing minor hikes in TRL/FX RRRs; ii) Maintaining the status quo, but providing the message that they stand ready to act, if need be; iii) A symbolic tightening in RRRs. We attach slightly higher probability to the second option, while acknowledging that a symbolic tightening in RRRs per se would strengthen the cautious stance regarding financial stability.

Last but not least, we attach significant importance to press reports claiming a lack of coordination between the CBT and the Banking Regulation and Supervision Agency (BRSA) and the subsequent joint denial by the institutions. Actually, we had emphasized the significance of coordination in our earlier assessment: “…The reserve requirement hikes introduced by the CBT within the first half of 2011 had not proved that effective in tempering loan growth; rather, loan growth was restrained eventually thanks to the measures adopted by the BRSA in June. While it might behoove the BRSA to act in a similar way in the coming months, we reckon the lesson hopefully drawn from the 2011 experience might lead to improved coordination among relevant institutions….” In this sense, the following joint statement by the CBT and the BRSA is relieving, in our view: “…Regulations that are relevant to more than one institution are discussed at the Financial Stability Committee level and any decision is made following mutual exchange of opinion. Our institutions will continue their works, as before, on the basis of rapport and mutual cooperation.”