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.”

Sometimes the Best Offense Is a Good Defence

The New Year kicked off with a distinct strengthening in global risk appetite, as the fiscal cliff was averted, albeit temporarily, thanks to a last-ditch tax revenue deal, along with a two-month reprieve to resolve the outstanding debt ceiling and spending cut issues. Not that the minutes of the December FOMC meeting left investors unfazed… While it was reiterated in the minutes that open-ended asset purchases would continue in the short term, the fact that some members cited the unfavourable consequences of QE, expressing their views that purchases could be pared back or even terminated mid-year, i.e. somewhat earlier than expected, provoked scepticism. The first reaction to this news unsurprisingly came from 10-year US treasuries, the yields on which jumped up to 20bp. Though the ensuing turmoil appears to have subsided in recent days, the fact that Governor Bernanke failed to clarify this matter in his first speech to follow the publication of the minutes meant the continuation of uncertainty, suggesting related developments should be closely monitored from the standpoint of market equilibria. As for the Turkish economy, we reiterate our view that the overarching theme of 2013 will be the preservation of gains. As such, we feel fine-tuning, rather than drastic changes in policy implementations, will suffice. The implication for the Central Bank is the establishment -- and even more crucially the safeguarding -- of an environment conducive to balanced growth. Besides, the Bank has signalled balanced growth for 2013 with its following statement: “We will let domestic demand contribute to growth to the extent that external demand recovers”. It will continue to communicate any progress to this end via the following three intermediate targets: inflation, loan growth and the real exchange rate. At this stage, given a lack of threats to medium term inflation outlook in terms of inflation expectations, the Bank appears more likely to focus on more imminent threats such as acceleration in loan growth and appreciation pressure on the TRL. Loan growth, which closed last year somewhat above targets and started the New Year with unabated strength, appears to be the key challenge for the Bank. To the extent that loan growth deviates from targets, the possibility of additional burdens on banks from the CBT and/or the BRSA will have increased. Nevertheless, we remain of the view that the Bank will not consider the loan growth target as a rigid boundary, rather that it will evaluate it with a flexible approach, taking into consideration its reflections on domestic economic activity. From a short term perspective, on the other hand, disclosures by the ECB suggesting the worst was left behind, and Spanish bond yields dipping below 5%, have contributed to an upbeat start to the year. While PMI indices, which we consider among the most crucial leading indicators, signify sustained recovery -- that is stronger in China and the US, and less so elsewhere -- the nearest hurdle that needs to be surmounted so that the recovery may gain traction appears to be the fiscal policy uncertainty in the US, which should be resolved until mid-February. As for Turkey, we observe some strengthening in growth as of the last quarter of 2012, though this still seems short of the potential growth rate. Initial growth rate forecasts for 2013 appear to average at around 4.2% levels. On the other hand, we reckon inflation may once again edge closer to 7% levels in January along with tax adjustments, though provided that the prevailing muted volatility in FX rates and commodity prices is sustained, we reckon any deterioration in inflation expectations seems unlikely. Initial survey findings point to 6.3% for YE13 average CPI expectations. As for markets, while the ISE benchmark index continues its venture “into uncharted waters”, we reckon we might have reached overbought territory and the odds of a shift henceforth to a sideways pattern appear to have increased. In terms of interest rates, on the other hand, the rebound we anticipated from historic lows has occurred and we now expect the upward trend to continue, and be more pronounced at the longer end of the yield curve. Regarding FX, in view of the CBT’s known stance and the framework it has drawn for real exchange rates, we do not expect the currency basket to slip below the 2.05 mark, rather to fluctuate within the 2.05 - 2.15 band through the course of the year.

Wall of Money in Land of Honey (MPC Preview)

The second Monetary Policy Committee (MPC) meeting of 2012 will be held on Tuesday, February 21. We and consensus expect no change in policy rates or in other monetary tools. However, given strong portfolio inflows in January and significant easing in financing conditions, the CBT may let the banks keep a greater portion of TRL RR liabilities in FX, in order to accumulate FX reserves, in line with their guidance at the latest investor meeting in Ankara. Currently the upper limit is 40%, but according to the CBT, the banks are utilising 35% of this facility for the time being.

The CBT may also retain the key message in its statement; i.e. “tight monetary policy stance should be maintained for a while in order to keep inflation outlook consistent with the medium term targets”. Moreover, the monetary authority could underscore once again the merits of preserving the flexibility of monetary policy, through referring to adjustment of TRL funding via one-week repo auctions in either direction, depending on developments in credit, domestic demand, and inflation expectations. Furthermore, we know from the last Inflation Report that CPI forecast of 6.5% is based on the assumptions that tight monetary policy stance will be sustained for a while; annualised loan growth rate will hover at around 15%; and the Turkish lira will display a mild appreciation trend.

However, the CBT may also start building the foundations of an alternative scenario of “strong inflows”, implying a strengthening in capital inflows to Turkey after the January FOMC decision, ECB’s LTRO, and new additions to QE by BoJ and BoE, though this may not necessarily be mentioned in the brief statement to be published after the MPC meeting. If this does turn out to be the case, however, it would be the exact opposite of the market conditions (outflows/weak inflows) that prevailed within October-December 2011. Note that the CBT has shared its possible monetary and macroprudential reactions for both cases in previous presentations.

Therefore, we expect the CBT’s responses to strong capital inflows to be in the form of 1) FX purchase auctions; 2) reducing the lower bound of the interest rate corridor to gain flexibility to ease monetary policy; 3) RRR hikes or at least a stable RRR level. H

owever, we think the CBT will not be in a hurry to switch to the aforementioned alternative scenario, since it seems content with some further appreciation of the TRL and would probably like to be sure about the permanency of capital inflows. Moreover, the pace of loan growth will be of utmost significance concerning this decision. The CBT has been indicating that annualised loan growth rate (FX-adjusted) at around 15% is reasonable for the inflation target. Therefore, the CBT will continue to observe whether the recent trend is in line with the explicit target and react accordingly.

When we look at the recent loan figures, interestingly we see divergent trends in consumer loans and total loans. According to weekly loan data from the BRSA, FX-adjusted (fixed rate, fixed parity) yoy growth is similar to the previous year-end (23-24%) and trend-growth (annualised 13-week average) of FX-adjusted loans still remains in the range of (10-12%) as of February 3. However, the trend indicator for consumer loans that the CBT is following (annualised four-week moving averages) stands at 2%, significantly below the related figures for 2011 and for the average of the 2006-2010 period. We attach greater significance to the trend in total loans, and low consumer loan growth does not seem disconcerting to us, since it is supportive for re-balancing of domestic and external demand. Therefore, we think the recent trend is in line with the explicit target. This implies an unchanged monetary stance and funding cost for the time being.

However, three scenarios are possible for the near future: 1) If loan growth remains roughly around 15% -- as it has recently -- the CBT will maintain the funding cost at its recent level (7.5%), but seriously consider launching FX purchase auctions in case of appreciation pressure on the TRL due to capital inflows. 2) If loan growth dips clearly below 15%, the CBT might adjust the parameters (lower and upper limits for the amount of 1-week and 1-month repo) of the interest rate corridor to ease the funding cost to below 7.5%. 3) Conversely, if loan growth climbs significantly above 15%, the CBT will maintain higher funding costs and even consider higher RRR.

As we review the economic outlook that sets a backdrop to the expected developments in monetary policy discussed above, the most crucial piece of fresh news seems to be the estimate-topping industrial production (IP) reading as of Dec’11. We expect the comparative heftiness of the YE11 IP level -- hence the level at which it starts the new year -- to induce upward revisions to 2012 growth estimates. Investors will recall that industrial production rose by 3.7% yoy in Dec’11, exceeding market consensus of 2.3%. More importantly, seasonally-adjusted (SA) IP jumped to a record-high 131.5 in Dec’11, 8% above the pre-crisis peak in 2008. Since the original series of the IP tend to be more volatile and sometimes misleading, we opt to use IP (SA) figures to construct different scenarios for economic activity. Although there are differences between the two series in mom comparisons, the results should be the same in yoy comparisons. Therefore, barring a permanent break in IP (SA) series, the current stronger path suggests enduring growth in IP, the most important leading indicator of GDP. That is why we flagged a probable revision to our GDP growth forecast towards 3.5-4% from 2.5%, immediately after the data announcement.
Consequently, we revised our 2012 GDP forecast to 4.0%, as part of our base scenario envisaging around 2.5% sequential contraction in IP (SA) for 1Q12, to be followed by c.3.5% recovery until the year-end.

We also present here our two alternative scenarios, in order to show what could lead us to make new revisions. 1) Bad case: Around 4.5% sequential contraction in IP (SA) in 1Q12, to be followed by around 2.8% recovery until the year-end – consistent with around 2.5% yoy GDP growth in 2012; 2) Good case: Around 2.5% sequential contraction in IP (SA) in 1Q12, to be followed by around 6% recovery until the year-end – consistent with around 5% yoy GDP growth in 2012. We also need to underline the fact that upward revisions to Eurozone growth in particular or global growth -- as has already been the case recently by some global investment banks -- would be supportive of our above-consensus GDP forecast -- and even our good case scenario.

Accordingly, we have tweaked our other macro forecasts in line with changes in our GDP forecasts. Additionally, it is worth underscoring that recent data point to growth that is driven more by investment and external demand than consumption demand. For example, while 4Q11 import quantity index contracted by 1.8% with respect to the same quarter a year ago, export quantity index expanded by 5.8%. Leading export readings (Turkish Exporters’ Assembly (TIM)) as of the early months of the year and leading indicators of consumption (automotive sales and CNBC-e consumption index) also seem to suggest a continuation of this trend. While we consider this new composition to be healthier and more constructive for the sustainability of growth, we also believe it should help accelerate a balancing of internal and external demand.

In conclusion, the CBT is once again likely to indicate that a tighter monetary stance remains warranted for some time and it will continue to respond to potential shocks with the interest rate corridor policy. Additionally, the monetary authority may emphasize that in the event that it becomes more confident of the sustainability of strong capital inflows, which have been evident as of the start of the year, it might initiate steps to enable FX reserve accumulation, such as scaling up of the permissible amount of TRL RR kept in FX, and launching FX purchase auctions. As for the direction of the funding cost that has long been hovering at around 7.5%: it will continue to hinge primarily on loan growth, and to a lesser degree on signals from economic activity and inflation.

“Let's Do The Things We Normally Do”

The first Monetary Policy Committee (MPC) meeting of the year will be held on Tuesday, January 24. The fact that exactly a week later the first Inflation Report of the year will be issued, makes this meeting all the more significant: the brief statement to follow the meeting will provide initial clues as to the type of monetary policy to be pursued by the Bank within 2012.

Investors will recall that in the waning days of last year, faced with the TRL hitting a low of 2.20 against the currency basket and year-end inflation set to reach double-digit levels, the CBT implemented a mode of tightening it termed “additional monetary tightening”. This was implemented mainly via open market operations, and the liquidity funded to the market at the policy rate was reduced temporarily below the lower bound announced for “normal” days, and was even halted for several days. Moreover, unsterilised foreign exchange sales and interventions were used as a complementary instrument. The CBT also defined the main characteristic of additional monetary tightening as follows: “It is intended to be temporary and the duration of the implementation may vary depending on the speed at which the main factors affecting inflation outlook turn favourable." Indeed, with the TRL -- a factor of paramount significance for inflation -- having started to appreciate visibly since then, the CBT loosened its grip by injecting liquidity at the policy rate after an 8-day pause. During the course of this implementation, the blended cost of funding shot up some days to 12%, resulting in an average of 10.5%. The average of the 1-month period preceding this tightening, on the other hand, was a tad below 8%. Recently, the cost of funding has reverted to the interest rate range envisaged for “normal” days by the Bank (“During the course of this period, O/N rates in the interbank will be aimed to remain within a band of 8-12%, and the weighted average of banks’ funding from the CBT at 5.75-8.50%.”)

Consequently, given the comparative success of the additional tightening, markets will try to gauge first and foremost the following from the CBT’s statement: for how long the Bank will continue to effectively utilise the interest rate corridor policy, which has allowed it substantial flexibility in monetary policy manoeuvres. While we stated earlier that we deemed this strategy creative and effective, we nevertheless recognize that the flexibility it provided to the Bank on the flip side meant uncertainty for market players. Given frequent changes in the rules of the game, the direction and amount of change in the cost of funding from today until tomorrow are far from predictable. This, in turn, continues to lead to an elevated risk premium associated with the policy implementation in all types of pricing. We have observed that the Bank, aware of this inconvenience, has started to share information with the market as to its potential responses -- such as the lower limit applied to funding at the policy rate -- in a bid to enhance predictability. However, sudden shifts in monetary policy driven by frequent changes in market conditions have prevented this constructive approach from being appreciated by market players, leading it to be perceived more as a policy swing. As far as communication policy is concerned, we hope that the CBT has drawn the necessary lesson from this phase.

In the first Inflation Report of 2012, we reckon the CBT will most likely reiterate its claim that the year-end target will be attained, predicating its argument on the tightening implemented in the final quarter of last year and the recent additional tightening. In this case, it seems rather likely that the monetary authority will refrain from pronouncing a probable interest rate path or the direction of the monetary policy (tightening/loosening) in its base scenario for the rest of the year. These will likely be provided in the framework of alternative scenarios, based on different eventualities in terms of global risk factors.

As such, the Bank will probably be inclined to maintain the interest rate corridor policy so long as market conditions permit. Furthermore, as interest rate decisions have to be made at the MPC, it will likely have to provide its guidance as to the ranges within which it targets funding costs to fluctuate. Based on our calculations, since October 20, the date of inception of the corridor policy, the average cost of funding is around 7.75%, while the Bank has opted to keep the cost of funding at 7.50%-8.00% excluding “exceptional” days. It is also worth underlining that during the investor meetings held in Ankara, the Bank expressed its view that 12% was an excessive rate in terms of economic balances (Brazil’s 11% policy rate is the highest on a global scale, followed by India with 8.5%), while noting that it deemed reasonable the 5.75 - 8.50% range it foresaw for December. (*)

As we have mentioned before, we see this experiment as a test drive to determine the equilibrium interest rate at which money demand is equal to money supply. We still think that as long as the average cost of funding of CBT facilities (1-week repo, primary dealers facility and O/N Lending) remains significantly above the policy rate, the odds for the policy rate (5.75%) getting closer to the CBT’s blended rate would be higher. This implies scope, when needed, for policy rate hikes to the tune of 200bp, which are likely to be front-loaded under these circumstances. However, the CBT still seems content with this policy and is unlikely to change its stance in the near future.

On the other hand, a rise in the cost of funding and the general interest rate above current levels does not seem justifiable at this stage, given i) the retracement in trend consumer loan growth towards 10% at the end of last year is sustained in the initial weeks of 2012 as well; ii) the 5% appreciation of the TRL; and iii) signs of a strengthening in rebalancing of domestic and external demand. Moreover, potential surprises in the short term in industrial production and inflation might reinforce this perception. Based on our preliminary estimates, a slight negative (first signal being a 7% contraction in automotive manufacturing in December) or a minor positive annual industrial production growth figure seems of significant likelihood. As for inflation, the easing in core inflation on an annual basis -- for the first time since November 2010 -- might be solidified by a stronger TRL, though this may not be the case for headline inflation, which looks set to remain elevated in the early months of the year due to the base effect.

In conclusion, at the upcoming first MPC meeting of the year, the CBT is likely to convey its view that the prevailing tightness level is adequate. The monetary authority is also likely to indicate that it will continue to respond to potential shocks with the interest rate corridor policy. In the coming period, the degree to which the cost of funding will undershoot the average (8%) of the monetary tightening phase, will hinge on the extent of TRL appreciation. A firming of the TRL in tandem with an increase in global risk appetite would strengthen the CBT’s hand in its bid to reduce the funding cost. In the event of stronger-than-expected capital flows, the CBT may also mull halting the FX sale auctions. In the opposite case, on the other hand, the cost of funding level would largely hinge on signals from loan growth, economic activity, and inflation.

(*) The CBT pursues different strategies in “normal” and “exceptional” days.
- In “normal” days, the CBT will continue to hold regular 1-week repo auctions at 5.75%, at an amount of TRL3bn-7bn, and the blended CBT funding cost (as a result of 1-week repo (5.75%)), O/N lending rate to PD (12%) and 1-month repo (yield to be determined through competitive bidding) will be sustained within an interval of 5.75-8.50%. Moreover, the CBT will sell US$50mn via daily FX sale auctions.
- In “exceptional” days, the CBT will discontinue regular 1-week repo auctions at 5.75%. Instead, it will hold intraday 1-week repo auctions through competitive bidding; i.e. the yield will be determined at the auction. Moreover, the sale amount will be higher than US$50mn at the daily FX sale auction, and the CBT might intervene directly in the FX market.

The Year of Living Dangerously...

CBT likely to stay its hand, for now... We do not anticipate a change in stance by the CBT -- as with the consensus expectation -- at the forthcoming final MPC meeting of the year, as the monetary authority sounds rather satisfied with the outcome of the new monetary framework since its date of inception, October 21; i.e. higher loan rates, lower loan growth, and a stable TRL. However, the reflections on macro framework are yet to be evidenced, with GDP growth -- especially domestic demand -- still vibrant, as suggested by 3Q figures; C/A deficit on the rise; and inflation double the year’s target. Although it looks like a typical time-inconsistency problem, the ex-post performance of previous attempts in restraining the “animal spirits” of the consumer understandably makes most investors lend little credence to a soft landing scenario. On the flip side, recent data should normally have assuaged hard-landing fears and made analysts more upbeat, due to strong growth momentum, whose effects will be observed going forward as well. Unfortunately, this is not the case either for the time being, given mounting EU-related concerns.

CBT’s Inflation Report due in Jan’12: Any inklings of a policy shift? The Eurozone conundrum is the predominant source of difficulty we face in setting our 2012 base case for global economic outlook, with the related uncertainty placing our main assumptions for the domestic economy at risk as well. At any rate, who could carry on with initial assumptions when underlying dynamics shift so rapidly in the global economic landscape? Lack of visibility also increases the need for flexible monetary frameworks for all central banks. That is why we judged the interest rate corridor policy to be an innovative response to prevailing global uncertainties and an instrument addressing the monetary authority’s need to gain time for improved visibility. We also see this experiment as a test drive to determine the equilibrium interest rate at which money demand is equal to money supply. We think that as long as the average cost of funding of CBT facilities (1-week repo, primary dealers facility and O/N Lending) remains significantly above the policy rate, the odds for the policy rate (5.75%) getting closer to the CBT’s blended rate (currently above 8%) would be higher than the reverse case. Based on latest available data, the average ISE O/N repo rate and average blended rate since the inception of the interest rate corridor policy stand at 10.6% and 6.9%, respectively. These figures point to 125-225bp scope for rate hikes when needed, which are likely to be front-loaded under these circumstances. However, the impact on loan rates would be similar and would not place any additional cost on top of that already generated by the interest rate corridor policy. The only difference is that tightening via the policy rate tends to be more permanent.

The main purpose of the interest rate corridor has also changed in time. At the beginning, it was aimed at fending off extreme depreciation of the TRL spurred by global factors. Recently, the trend in loan growth is driving the fine tuning by the CBT. We perceive this as a prudent move, since otherwise it would be extremely difficult to defend certain parity levels amid spikes in risk aversion. The corridor policy should thus continue to help alleviate currency volatility, as stressed by the CBT in recent presentations.

All in all, we continue to think the CBT will need to review this policy after a few months’ implementation, if the global outlook becomes less ambiguous -- for better or worse -- and possibly take a clearer stance on the policy rate (or policy mix) path in the first Inflation Report of 2012 due to be published by end-January, the earliest.

Economy on a slower growth track, based on recent data... Having made our aforementioned assessments on monetary policy, we also find it worthwhile to briefly discuss the current macroeconomic outlook and our base scenario for 2012. In line with the evaluations provided in our earlier reports, and supported both by data releases as of 3Q11 and leading indicators for 4Q11, a rather gradual slowdown remains underway in the Turkish economy, lending support neither to overheating nor to hard landing concerns. A major change appears under way as of the first month of 4Q11 in terms of private consumption and private investments, which had remained strong in the first nine months of 2011, despite all the tightening measures adopted by the Central Bank. Consumption goods and investment goods imports, which had grown by 32% and 48% yoy, respectively, in the first nine months of the year, posted a limited contraction in October. Leading indicators like automobile sales suggest there might be more to come. Similarly, the Consumption Index published by CNBC-e, which might be construed as Turkey’s retail index, has decelerated to 1% growth in November, down from 14% as of the first nine months of the year.

We expect such an outlook, also supported by the high interest rate environment prompted by monetary tightening, to reduce the final quarter’s growth to at least half the 8% observed in the preceding two quarters. While it appears that the re-balancing act anticipated in foreign demand has already started in 3Q11 (volume growth of exports has exceeded imports), foreign trade index readings as of October suggest that this still remains under way. Moreover, the rise in exports on a US$ basis remains quite significant, despite Eurozone related risks and the slowdown under way for quite some time. Although the month of December will see export growth touch its trough year-to-date mostly on the back of last year’s high base, final quarter exports growth is forecast at 10%. While a rather clear slowdown is evident here, the ratio of exports to GDP at 15%, trailing both private consumption (70%) and private investments (20%), underscores the continued relative significance of “final domestic demand” for the Turkish economy, and the fact that Turkey may emerge relatively unscathed from this turbulence, provided that household confidence is sustained and expectations are well managed. Moreover, it should be kept in mind that the share of exports to the EU in total exports, currently slightly below 47%, have been on a declining path in recent years, while their ratio to GDP of 7% is markedly below the EMEA average of 18%. On the other hand, in the event that the EU economy plunges into a deep recession -- unlike the consensus expectation of a limited growth -- the ensuing effects on the Turkish economy would be not only through trade but also through financial channels, i.e. banking relations. This effect might become evident through a diminution in short and long term credit flows to the banking and the non-financial private sector, which are also crucial for the financing of the current account deficit.

Considering the causality between the current account deficit and growth, the implication for the Turkish economy would be the related sectors and hence the overall economy sliding to a lower growth path. The magnitude of the decline in growth would hinge on the roll-over ratio of loans due in 2012. During the global crisis, roll-over ratios for long term loans had declined to 78% for the banking sector and to 71% for the other sectors. It might be feasible to assume these as the lower limits in the event of a credit crunch. Nevertheless, it is worth underlining that as of the end of October, reported roll-over ratios are far above the aforementioned ratios.

A hard landing -- rather than a balance of payments crisis -- seen as the worst case scenario -- Based on our calculations, Turkey’s aggregate foreign debt redemptions (public + CBT + banks + private sector) due in 2012 are around US$135bn. Of this amount, about US$65bn will be repaid by the banks and US$59bn by other sectors. Out of the debt repayments by the banks, a US$32bn portion pertains to loans, and the remainder to FX- and TRL-denominated bank deposits. However, about US$16bn of the bank deposits will be repaid to domestic banks’ branches and affiliates abroad. In other words, they are not an external liability in essence, and are easy to roll over. It was also disclosed by the CBT at the Financial Stability Report that about US$18bn of the redemptions by the banks would be related to syndications/securitisations. It is a commonly agreed upon fact that such loans are an outcome of long-standing relations and a full renewal would not be difficult, if sought by the borrowing bank. As far as the corporate sector is concerned, of the US$59bn total repayment, a US$27bn portion is related to trade credits, i.e. liabilities arising from L/C of imports and pre-financing of exports. These are also liabilities based on developed trade relationships, hence probably not difficult to roll-over either. Of the US$32bn loans ostensibly borrowed from abroad, a c.US$10bn portion pertains to domestic banks’ branches and affiliates abroad; hence, no roll-over difficulty is envisaged. Considering all these factors, an overall US$200bn foreign finance requirement -- including a US$63bn C/A deficit based on our estimates -- for 2012, which looks astounding at first glance, becomes more manageable. Even in the event of rather low roll-over ratios, the implication would be a hard landing, rather than a balance of payments crisis, in our view.

Maintaining our 2.5% growth estimate for the Turkish economy in 2012 -- In conclusion, EU related risks, i.e. recession and deleveraging, remain to be the foremost risk factors facing Turkey’s growth prospects, despite all the mitigating factors cited above. On the other hand, recent data on exports and foreign finance do not reveal any notable worsening in Turkey’s case attributable to the EU. Should the aforementioned risks fail to materialise, the recent strong growth momentum in the Turkish economy might lead it to sustain a relatively impressive growth rate in 2012 -- such as the 4% targeted in the Medium-term Economic Programme (OVP) -- as well. However, given the prevailing environment of uncertainty, with a cautious approach, we continue to consider 2.5% as a plausible growth rate for the Turkish economy in 2012, in a scenario whereby risks partly become reality. On the other hand, in the event of a marked deterioration in trade, finance, and expectations, the three channels via which external shocks may be transmitted to the domestic economy, stagnation or even a mild recession might well be the case.

Kicking The Can Down The Road...

We were one of the very first macroeconomics teams to have stressed the need for tightening prior to the October MPC meeting, as outlined in my article entitled “Hawks to the Fore” published on October 17. Moreover, after the MPC’s decision to widen the interest rate corridor, we underlined that this was the least the CBT could do for the time being, also reiterating our view that the inflation outlook and the TRL still warranted a much tighter stance than the current one.
However, the CBT appears satisfied with the outcome of the new framework since its execution as of October 21; i.e. a stronger TRL and higher loan rates. The average O/N repo rate has jumped to 10.0% as of then, compared to the previous 1-month average of 6.2%. Moreover, after several days of implementation, the CBT Governor indicated at an investor meeting that they did not intend to keep O/N rates at unnecessarily high levels in normal market circumstances, provided that credit conditions remained tight and the TRL stabilised at around current levels. In our view, this statement attests to the flexible and temporary nature of the interest rate corridor policy, also indicating that the CBT continues to kick the can down the road.

As we have been underlining from the very start, we consider this strategy viable and effective, but do not think the divergence of the O/N rate from the policy rate is sustainable for long, as the reference rate in that case loses its significance. Normally, the CBT’s tightening stance would justify an outright rate hike -- not the current “hike in disguise”, we think. Although, one might still give the CBT the benefit of the doubt, on the premise that the reluctance to use the policy rate hike mechanism is driven mainly by global economic uncertainties, it seems more probable that this preference will be perceived as the main flaw of the tightening stance and its adequacy will be increasingly questioned down the line. Therefore, we think the CBT will need to review this policy after a few months’ implementation and possibly take a clearer stance on the policy rate (or policy mix) path in the first Inflation Report of 2012 due to be published by end-January the latest.

In an inflation targeting regime where there is a small output gap -- and irrespective of whether the regime is flexible or not -- a central bank should act in a permanent tightening direction only when there is significant deterioration in inflation expectations, as gleaned from expectations surveys or market-based indicators, such as in terms of bond yields and breakeven inflation* in CPI linkers. The reasons underlying higher inflation expectations (depreciation of the currency or higher import prices) are of no significance for a central bank. Three indicators are crucial in this respect: 12-m and 24-m forward-looking CPI expectations from the CBT’s twice monthly survey; 2-year or benchmark bond yields; and B/E inflation level for the CPI linkers. Currently, all of the three indicators are at recent highs. However, this is not a fresh development and more importantly the deterioration has not been significant after the administrative price shock in October and the CBT’s upward revision of year-end CPI forecasts. For now, this is somewhat relieving, but we should follow them closely, as they remain susceptible to macro surprises, going forward.

Having said that, we tend to take a fairly lenient view of this somewhat controversial monetary policy framework the CBT has been implementing since November 2010 in the remainder of this report.

Evolution of “Monetary Policy A La Turca” in Brief

One of the most crucial lessons to have emerged from the global crisis on monetary policy is that failure to safeguard financial stability might lead to the disruption of macroeconomic and price stability in the medium term. In this framework, the notion that central banks should not remain oblivious to asset price bubbles or to risks accumulating in the financial system has been gaining widespread acceptance. This situation has prompted a number of central banks to integrate measures aimed at safeguarding financial stability into the framework of monetary policy, setting the stage for non-conventional monetary policies, which have started to be used extensively by advanced and emerging countries’ central banks.

The Central Bank of Turkey (CBT), one of the first central banks to have mentioned financial stability, has launched works to expand and activate the set of instruments necessary for a monetary authority targeting price stability along with policies intended to defend macro financial stability, as of mid-2010. To this end, the monetary authority has decided to use the reserve requirements and the interest rate corridor (the difference between ON/ borrowing and lending rates) as other instruments alongside the policy rate. In a bid to enhance the effectiveness of reserve requirements as a policy tool, the CBT has ceased paying interest on the reserve requirement liabilities of the banks.

This new approach envisaging the usage of more than one policy instrument by the CBT entails certain risks, such as i) misunderstanding (emphasis on financial stability might create the misperception that deviations from the inflation target might be tolerated); ii) facing difficulties related to communication (the absence of a clear-cut theoretical framework or concrete findings for the effectiveness of non-conventional monetary policy instruments). Moreover, the fact that the Bank has deliberately created uncertainty to deter short term capital inflows at the start of the application, and has predicated its monetary policy communication on the concepts of “policy mix” and “monetary tightening”, rather than providing guidance on interest rate path as in the past, prompts the perception that it will take some time for market players -- accustomed to the previous policy implementation -- to comprehend and accept the new approach.

Although the monetary policy mix concept might seem complicated at first glance, it may be considered as a more flexible form of inflation targeting. While the principal criterion in monetary policy decisions is again deviation in inflation expectations from target, this time macroprudential tools are also brought into the equation, so as to contain financial risks. Hence, monetary policy stance is determined by short term policy rates, as well as the net balance of other variables determining monetary conditions, such as reserve requirement rates and the liquidity situation in the market. How and in which direction policy instruments will be utilised, on the other hand, is designated by price stability and factors affecting financial stability.

This graphical representation of the monetary policy recently introduced by the CBT depicts a variety of policy responses by the monetary authority towards fulfilling its mandates of attaining price and financial stability. While the CBT has started to utilise this framework in its communication as of the final months of 2010, the evolution of policy mix as of then is traceable from the graphical representation above.

It should primarily be underlined that the CBT’s primordial goal is the attainment of price and financial stability, the two main axes of monetary policy. In terms of graphical representation, this would imply being at the crossing point of the four main blocks, i.e. meeting the targets, while corresponding to a neutral stance from a monetary policy standpoint. The choice of monetary policy response hinges on which of the four main blocks we are at (or at which of the four main blocks the Bank perceives us to be). While the state of price stability is determined by whether inflation is on an accelerating or decelerating tendency, from the standpoint of financial stability, key determinants are whether credit growth is on the rise or on the decline. As an example, the policy response given as of November 2010 -- at a time when inflation was on a downward course yet credit growth on the rise -- was a combination of tightening of policy tools other than interest rates (liquidity withdrawal and increases in reserve requirement ratios) and easing in policy rate; i.e. corresponding to Block A.

In the framework of the new monetary policy implementation, there have been two shifts in blocks -- one of them quite recent. The first one of these came right on the heels of the July Inflation Report, when an extraordinary MPC meeting was held amid mounting uncertainties surrounding the Eurozone. The monetary authority then drew attention to global risks as well as to the prospect of a recession in the domestic economy, conveying the view that all instruments would be used in an expansionary manner. The decisions that followed proved consonant with this message, implying a transition to Block B, i.e. the state where policy rate and instruments other than interest rate are employed in an expansionary mode. However, this positioning proved short-lived. With the upward tendency in inflation gaining pace and the ensuing shock to administered/guided prices in October adding further momentum to price increases, the Bank was compelled to switch to a tighter monetary stance. However, this monetary tightening was not in the form of a direct policy rate hike that would comply with Block C, rather through allowing the O/N repo rate to drift higher than the policy rate while expanding the interest rate corridor. Instruments other than the interest rate, on the other hand, were used as expected, with the reserve requirements imposed on TRL liabilities scaled down by 200bp on average, in a bid to alleviate the shock on deposit and credit costs.

It is worth underlining that actual monetary tightening was not as strong as the perception created by O/N repo rates initially hovering at and above 10%. From the perspective of a bank’s funding cost, more than the prevailing rate at the O/N repo market, it is the portion of the funding that the CBT provides via the 1-week repo auction at the 5.75% policy rate. From this standpoint, it is observed that a major portion of the funding need is still met through this channel. Based on our calculations, which incorporate the funding banks receive through mutual funds and repo transactions with clients, alongside the funding provided by the CBT channels (1-week repo, market making, lending), the average funding cost has increased up to 7.8%, up 180bp, from about 6% prior to this implementation. The effect would have been similar, had the tightening been through the policy rate. The only difference is that tightening via the policy rate tends to be more permanent, while that through widened interest rate corridor, given its flexible nature, might prove temporary based on the market conditions that follow.

The fact that the CBT has opted for this mode of tightening might be attributed to the prevailing global uncertainties in the current environment and the monetary authority’s need to gain time for better visibility. In its latest Inflation Report, the CBT declared its 2012 inflation estimate at 5.2%, based on the assumptions that “the gradual slowdown in consumer loan growth continued and that in the framework of the policy decisions made in October, monetary conditions were markedly tightened in the final quarter of the year”. Given the ambiguity of this message sentence in the section of the report devoted to policies, it does not appear possible to clearly discern until when this seemingly temporary tightening will continue and the nature of the stance that will replace it in the new year. In the coming period, barring a marked deterioration in forward looking inflation expectations, we reckon the Bank will be inclined to sustain this strategy. Otherwise, we believe the Bank will need to render monetary tightening permanent through the policy rate.