Rebalancing Bargain...

Summary: Whether you name it the “currency wars” or the war between Asian reflection and U.S. deflation, the implication would be intensified financial stability risk for Turkey, where growth is already constrained by the depressed external demand. Turkey is among the countries that exacerbate the global imbalances, which is seen as the culprits of the wars. Instead of pushing forward with the reforms to address the structural deficit, Turkey has so far been more engaged in reducing risks regarding the deficit financing. The Central Bank has taken such measures and they will likely continue doing so in the upcoming period to curtail these risks.

The surprise rate hike from the Central Bank of China last week has raised speculation regarding the G-20 decisions to be shaped at their weekend meeting. Moreover, this tightening move from China induced the markets to deviate from their current trend and exacerbate the market volatility. Basically, what we see was the softening of EUR/$, accompanied with the stock market sell-off. The mentioned speculation is about a “grand bargain between the U.S. and China.” The bargain assumes that the Federal Reserve to be less aggressive in an expected second round of quantitative easing when the FOMC meets on November 3rd in return for China tightening monetary policy and letting their currency Yuan to appreciate at a faster pace. On the other hand, Martin Wolf in example, from Financial Times is in the camp that perceives the recent developments in the context of a war between Asian reflation and U.S. deflation. Wolf says the U.S. would win the war thanks to their ability to print unlimited amount of dollar which is the reserve currency (either by pushing inflation higher or appreciating currencies against dollar in the rest of the World). The first rate hike from China since end-2007 is also interpreted to be a pre-emptive move, hinting that the monetary policy tools, aside from the F/X policy are part of the arsenal now. All in all, it is believed that the countries in Asia would guard against the ultra loose monetary policy objective of the U.S. which would export inflation to Asia through asset price bubbles. The market has perceived this new battle to be a risk against asset prices and the risk appetite has lost some ground. It is difficult to argue which of the above theses is true. However, there is one thing certain that the World continues to suffer from the lingering malaise in the post global crisis environment. Whether you name it the “currency wars” or the war between Asian reflation and U.S. deflation, the implication seems to be intensified financial stability risk for Turkey, where growth is already constrained by the depressed external demand. The good news is that the Central Bank has already been underscoring these risks for a while and acting fast in launching measures to combat these risks.

Behind the wars lie the global imbalances (high current account surplus in Asia, high C/A deficit in the U.S.) which failed to be corrected by the crisis, while the decoupling between countries during the recovery has made the situation even worse. In that context, the issue of maintaining a strong, balanced and sustainable growth has also been discussed by Oliver Blanchard, IMF Economic Counselor, who emphasized the difficulty of reaching this goal and outlined two complex global rebalancing acts that are required. First, internal rebalancing, that is based on the private demand taking the lead again in developed countries and on the consolidation of fiscal balances that were ruined during crisis. The second aspect of rebalancing is external rebalancing, which includes many advanced countries, most notably the U.S., relying more on net exports and many emerging countries, most notably China, turning more to domestic demand. Blanchard says both of these balancing acts have been proceeding, albeit at a very slow pace.
Turkey is also among the countries that inflate the global imbalances with an estimated current account deficit of above 5% this year. In essence, both cyclical and structural factors play role in rapid expansion of the current account deficit in Turkey, which in that sense does not match the emerging market prototype having external surpluses on the back of their commodity or industrial goods exports. Nevertheless, instead of pushing forward with the reforms to address the structural deficit, Turkey has so far been more engaged in reducing risks regarding the deficit financing that has become more vulnerable recently.

The Central Bank’s decisions announced from September onwards are also in this category. In our previous posts, we mentioned about how the Turkish Central Bank describes the new conjuncture. The Central Bank had warned that the intensive capital flows into trusted and dynamic emerging market economies during this period underscore the risk of overheating, excess borrowing and emergence of asset bubbles in these economies, eventually pushing the current account deficit to levels that may jeopardize the financial stability. The Bank had also said that the Bank’s latest decisions (about required reserves and F/X purchase auctions) should be seen as a preparation in advance of the new conjuncture. The Central Bank continued to stress these risks in the MPC meeting held afterwards. In the last meeting, the Bank said ‘While not yet a significant concern regarding financial stability, the Committee has indicated that these developments support the implementation of the “exit strategy” measures.’ As we noted many times before, we expect these measures to continue, while the pace of domestic demand, in particular the domestic loan growth rate of the banking system, would be the key criteria in determining how fast the Central Bank would act. The weekly data for domestic loans have so far implied no change in the rate of expansion since the measures were taken.

In the Inflation Report due October 26th or in the 2011 Monetary and Exchange Rate Policy due December, the latest, the Central Bank would likely outline in more detail the roadmap about required reserves, which have become a more effective tool in curtailing macroeconomic and financial stability risks. This would help the banking sector to better visualize the future and hence fulfill their intermediary role between the monetary authority and the household and real sector in a more stable way.