Hawks to the Fore....

This month’s Monetary Policy Committee (MPC) meeting (October 20) is even more significant than it usually is. First of all, it will be followed by the quarterly Inflation Report (October 26), hints regarding which will probably be provided in the accompanying statement. Secondly, the CBT had stated at the extraordinary MPC meeting dated August 4 -- right after the issuance of the previous inflation report -- that it was shifting towards the more pessimistic scenario, and started to make decisions compatible with this stance. Hence, the forthcoming statement is significant in that, the new base scenario will gain an official status with it. Yet, what is even more important than these two factors is a possible indication the statement might provide as to the type of monetary stance the CBT will opt for to meet next year’s 5% inflation target, having let this year’s inflation rate digress substantially from target.

Let us assert our conclusion at the very beginning: this ambitious target prompts a tighter stance than today. Should the CBT communicate a policy guidance, this will be included in the brief message sentence where it typically provides its inflation estimates. At the July statement, it was indicated that assuming that the annual rate of credit growth declined to 25% by the end of 2011, and the policy rate remained constant until the end of 2011, inflation was expected to be 6.9% at the end of 2011, and 5.2% at the end of 2012. As of then, there have been major changes with respect to the assumptions included in this sentence, as well as the course of inflation. First of all, the 25% credit growth target has been revised to indicate an annual credit growth rate of 25% adjusted for the FX effect. Secondly, the policy rate has not been kept stable; rather, a 50bp rate cut has been effectuated as of August 4. Thirdly, with the loss in value of the TRL having outpaced the expectations, inflation is expected to even exceed the CBT’s target (6.9%), which was already above target (5%), by the year-end. In our opinion, the CBT will be inclined to convey the message that at some point within today and YE12, it will need to embark on a measured tightening of the policy rate or policy mix, given that a marked divergence from the YE12 inflation target, which is within its control horizon, will not be permissible. At a time when it is widely discussed that all policy instruments might be employed in an expansionary mode due to downside risks, the Bank signalling some kind of tightening, albeit for a future period of time, would undoubtedly have an element of surprise to it.
While it would be rather difficult to gauge the precise timing of a potential tightening, it seems rather unlikely before the second quarter of 2012. Another possibility would be the Bank not signalling a tightening stance, rather shifting to a neutral stance, which would imply that policy instruments would not be employed in an expansionary mode. The fact that the Bank has recently adopted an approach that lays emphasis on growth and financial stability leads us to conclude that this possibility should not be underestimated either.

On the other hand, it appears that the CBT will revise its YE11 CPI projection to minimum 7.8% from currently 6.9% as MTP shows, or even higher to around 9% if all STC adjustments considered. The key factor underlying this revision would be import prices and the wider-than-projected depreciation of the TRL, while the fact that food and oil prices trend below projections (7.5% and US$115) will have precluded a greater deviation. Furthermore, a limited downward revision of the output gap, which denotes the difference between potential and realised growth, also seems in the cards.

Ahead of critical days when we expect the CBT to take the aforementioned decisions, we also opted to take a look at the current state of economic affairs. We aim to provide below a general review of the economic situation, without going too much into the details.

It could be stated that a rather gradual slowdown remains underway in the economy, lending support neither to overheating nor to hard landing concerns. While exports are yet to return to their pre-crisis levels due to the anaemic recovery in emerging economies and the Eurozone’s debt woes, the 20+% growth rates as of the first half of the year have been sustained, and the Export Quantity Index -- indicative for GDP computations -- has posted an increase slightly above 10% within July-August compared to the year-ago period. On the other hand, in the comparable period, the pace of growth in imports has eased notably (28.2%) compared to the first half of the year (43.5%), and the increase in Import Quantity Index has remained at 6.5%. This might suggest that net external demand might contribute to growth following a prolonged hiatus. As for the other major constituent of growth, domestic consumption, leading indicators point to a strengthening of the slowdown evident in the second quarter. While the 25% growth recorded in the total automotive sales in the second quarter has given way to c.2% contraction, CNBC-e Consumption Index, which comprises this sector’s data along with other consumer durables and retail products sales, also validates this picture. The Index, which posted respective growth rates of 22.9% in the first quarter and 15.5% in the second quarter, slowed down to 4.7% for the third quarter. Hence, it might be concluded that the re-balancing of domestic and external demand remains underway, and serves as a basis for the reversal of the deterioration in the C/A deficit. One critical signal to this end was received in August, when growth in the 12-month cumulative C/A deficit excluding energy came to a halt. However, one key factor to have precluded the visibility of the improvement in the short run has been the jump in gold imports in recent months. While Turkey has undertaken gold imports worth US$1.17bn in August, this figure is estimated to have risen to US$1.25bn in September. On the other hand, excluding energy and gold, the annual increase in imports as of August (16%) remains well below the total imports growth rate of 26%.

On the investments front, a pronounced slowdown is underway as well. Data related to imports and production of capital goods as of the third quarter point to similar results. While the rate of growth in imports has retreated from 63% to around 28%, production growth has slipped from above 20% levels to slightly below 10% as of the end of August. Given that 6.6pp of the 8.8% growth in GDP as of the second quarter was driven by private sector investments, it appears that private sector investments look set to drag the growth rate lower in the final quarter of the year. Hence, a decline in real growth in GDP to below the 4-5% range within the third quarter seems of significant probability, which implies that the qoq change in seasonally-adjusted GDP will have slipped to negative territory for the first time in a long period of time.

On the inflation front, while the headline inflation (CPI) follows an uneven course, core inflation has been posting an uninterrupted upward trajectory. The CBT has expressed its view that the H index, which had been reported at 7.4% as of the end of September, would reach 8% in the final quarter, and that core inflation would shift to a declining course as of the early months of the new year. The primary basis for this expectation is that the monthly change in the seasonally adjusted core inflation was a limited 0.3% on average in the final quarter of last year; i.e. setting an unfavourable base effect, though rose to 0.8% and 0.6% levels in the first and second quarters of 2011; i.e. setting a favourable base effect. It is worth reminding investors that while the seasonally adjusted core inflation growth consistent with the coming year’s inflation target is 0.4%, a rate of increase of 0.5% has been recorded in September. While increases in import prices prompted by advances in commodity prices, along with losses in the value of the TRL tend to put upward pressure on inflation, conversely stability in these variables prompts a return to averages consistent with the inflation target. In analyses conducted in Turkey, generally focus remains on the exchange rate pass-through effect, while pass-through from import prices tends to be ignored. However, CBT studies indicate that the pass-through from these two factors is comparable at around 15% each. The notable increase in core inflation this year stems from the fact that both variables have posted substantial increases. As such, for the CBT to be vindicated in its expectation of a decline in core inflation, the TRL should no longer lose value, and a fresh wave of commodity price increases should not be observed. Otherwise, even if the TRL were to depreciate, there would need to be a concomitant decline in commodity prices to offset this effect, as had been the case during the global crisis that erupted at the end of 2008.

Our final words are on exchange rate policy and FX reserves. Due to the factors we have drawn attention to above, the widely held perception is that the CBT is inclined to switch from the free floating exchange rate regime, in effect since 2002, to a managed float. The CBT, given its frequent verbal and direct interventions, does not seem to deny this perception. One source of concern here is that the rapid reserve erosion might heighten scepticism as to the sufficiency of the Bank’s FX reserves, potentially lifting Turkey’s risk premium. The related IMF guideline is for FX reserves to be at a level to meet 3 months’ imports, along with the entirety of short-term debt. Based on recent figures, Turkey’s respective levels are 4.3 months and 98.5%; i.e. not comfortably above the respective thresholds. Moreover, Turkey ranks at the lower end of the scale on an international comparison basis. The CBT, aware of growing misgivings, introduced a new definition to help markets gauge the effectiveness of the reserves, at the latest meeting in Ankara. To summarise, the Bank comes up with a variable that incorporates all external debt with maturity below 1 year -- more indicative than the short-term foreign debt stock -- and excludes foreign liabilities arising from the overseas branches of local banks, thereby reaching a more realistic foreign debt value. This rate, while being slightly below 100% as of end-July, is nevertheless significantly more comfortable than the 73% level as of 2008 and 86% for 2009.

In fact, the message that the CBT aims to communicate is that the FX reserves are more sufficient than during the global crisis and that the Bank would not fear losing reserves if need be, even if such a move would force the relevant adequacy ratios lower. As an example, FX reserves should decline to up to US$63bn for the adequacy ratio to return to 2008 levels, and to US$75bn to 2009 levels. As underlined earlier, more than 99% of the Bank’s reserves are usable and liquid. Furthermore, the CBT has a net FX surplus of US$55bn, accumulated over the years by the CBT through FX purchases in exchange for the TRL, and fully owned by the Bank. The remainder of the reserves comprise the banks' FX RR, the Treasury’s FX deposits and Dresdner Accounts (non-resident Turkish workers abroad) liabilities. Hence, while we reckon the Bank will be frugal in its use of FX reserves to the extent possible, we think it will not refrain from engaging in sizable FX sales when necessary. Yet, even this stance does not change the fact that the fate of the TRL remains linked to non-resident portfolio flows, which in turn hinge on global risk appetite. If the Bank does not introduce a new tool such as allowing banks to hold their TRL reserve requirements in FX, it could opt to use the following instruments to increase FX liquidity: reduction in FX RRRs (the 11% RRR for maturities up to 1 year might be reduced up to the pre-crisis level of 9%); a proportional increase in the %age of TRL RRRs that may be kept as FX (the 20% rate may be raised in tandem with the banks’ ability to borrow from abroad); re-activation of the FX depo facility (this facility, whose limit was set at US$10.8bn, has been dormant; usage might be encouraged through a reduction in interest rates); continuation of daily FX sell auctions; and direct FX sales to banks.

To sum up, if the Bank maintains its current stance for the short term, yet signals a more hawkish stance for the medium term, in line with our expectations, we reckon this would support the attainability of the 2012 inflation target; would be more convincing from an expectations management standpoint; and would underpin the value of the TRL against hard currencies. This support would be stronger if the signal were in the form of a policy rate hike, though somewhat limited if via policy mix tightening. If the monetary authority merely signals a transition to a neutral stance, it will have scuppered a genuine opportunity. This is because, signalling a tightening stance today would not amount to a pledge, as this signal might be changed, going forward, in line with global and local conditions. However, refraining from sending this signal today and doing so in the future when it becomes a necessity would largely diminish the benefit of the move.