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.

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.

Investor's Guide to the Fiscal Galaxy

The medium-term programme, which is expected to be unveiled in conjunction with the 2012 draft budget by October 17 the latest -- the latter as per a constitutional requirement -- is keenly anticipated by market players. Key aspects of the programme that are eagerly awaited are the macro framework to be presented for the 2012-2014 period and measures to be adopted to prompt structural improvements in the C/A deficit, as well as budget targets that will help us gauge the role accorded to public savings in this process. Issuing this report ahead of these crucial disclosures, we aim to provide investors with an insight into where Turkey stands from a fiscal balances perspective and -- making use of the IMF’s recently issued ”Fiscal Monitor” study -- make an assessment of the status quo with a global perspective. This way, once budget targets for the coming years are announced, we aim to be ready to figure out what they represent from a fiscal stance standpoint.

Global perspective: Turkey compares favourably with global peers in terms of key budget performance indicators; yet... Starting our analysis with the global comparison, we infer from last week’s IMF data, disregarding minor differences in definition, that Turkey ranks highly favourably on the basis of the 2011 values of the “general government balance (% of GDP)” and the “general government primary balance (% of GDP)”. While the respective values for Turkey are -0.9% and 1.8%, the global averages are -5.0% and -3.0%, and the comparison does not change when conducted on the basis of developed or emerging countries. Nor does Turkey’s comparative ranking change when the budget is adjusted for cyclical effects. With respective values of -2.1% and 0.6%, Turkey still stands well above comparable global averages of -4.1% and -2.2%.

...actual budget balances need to be cyclically adjusted... It is worth underlining that actual budget balances are imperfect indicators for assessing public finances and fiscal policies, since they are influenced by a number of factors that are both transitory and beyond the direct control of fiscal authorities. Predominant among those are the fluctuations in economic activity. The indicators of cyclically-adjusted budget balances seek to correct the fiscal outcomes for the effects of cyclical variations. In other words, they aim to determine what the budget balance would have been if the economy were on its “normal” growth path; i.e. characterised by roughly constant increases in output over the medium-term.

The IMF method... A number of different methods could be used for this adjustment process, out of which we have opted for the IMF method cited in Regional Economic Outlook 2006, for the sake of simplicity and convenience.

With this analysis, we aim to discern the nature of the fiscal stance (pro- or counter-cyclical) pursued in recent years and whether a fiscal impulse has been utilised. To this end, we have implemented the IMF’s methodology for fiscal impulse calculations, developed by Abrego and Clements. According to this methodology, fiscal impulse is the change in fiscal stance between two consecutive years, which in turn is calculated as the difference between the actual and cyclically neutral fiscal balance. Implementation of an expansionary (contractionary) fiscal policy in times of economic contraction (expansion) points to the presence of a counter-cyclical fiscal policy. On the contrary, implementation of a contractionary (expansionary) fiscal policy in times of economic contraction (expansion) indicates that the fiscal policy is pro-cyclical. The details of the methodology are presented below (Annex)

Our assumptions... Before proceeding to the findings of our study, we find it worthwhile to lay out a few key aspects of our assumptions. Similar to the IMF’s methodological approach, we assumed Turkey’s potential growth rate as its average growth rate for the past 20 years; i.e. 4%. Moreover, as the base year for our calculations, we opted for the year 2007, which preceded the inception of the effects of the global crisis, and we assumed that in that year there was no output gap; i.e. nominal GDP was equal to potential GDP.

While computing the “primary balance to GDP” ratios on an annual basis using current GDP data and budget primary balance realisations, we also aimed to calculate the cyclically-adjusted “primary balance to GDP” ratios, employing the potential GDP level. As with the IMF method, to compute cyclically-adjusted revenues, we multiplied the base year “revenues/GDP” ratio with the actual GDP level of each year, and to estimate cyclically-adjusted primary expenditures, we multiplied the base year expenditures/GDP ratio with the potential GDP level of each year. Hence, the difference between cyclically-adjusted revenues and primary expenditures provides the “cyclically-adjusted primary balance to GDP”, and the difference between the latter and the “actual primary balance to GDP” reflects the fiscal stance of a given year. A positive difference would indicate an expansionary fiscal policy. The difference in “fiscal stance” in between two consecutive years would tell us whether and to what extent “fiscal impulse” was applied.

Our findings... As is evident from the table below, while the fiscal stance is found neutral in 2008, the 1.7% value computed for 2009, when fiscal measures were adopted to assuage the effects of the global crisis, unsurprisingly points to an expansionary fiscal policy for the year. The 1.9% value computed for 2010, on the other hand, indicates that although the effects of the crisis have dissipated, fiscal policy still remains expansionary and that despite growth having reached 9%, “fiscal impulse” has been used, albeit to a limited degree. However, in a year whereby the C/A deficit to GDP ratio deteriorated markedly, at least a “neutral” fiscal stance would have been a more appropriate choice, in our view.

It seems somewhat premature to make an assessment of the year 2011 from a fiscal stance standpoint. This is because the current performance is ahead of the fundamental aggregates such as growth and inflation foreseen in the macro framework of the medium-term programme for the year 2011. Moreover, the budgetary effects of the restructuring of public receivables are perceived to have become sizable. According to our estimations, based on a growth forecast of around 6%, the neutral primary balance to GDP level for the year 2011 would be 3.1%. We should note that each 0.5bp growth overshoot would prompt a 0.1bp upward shift in this balance level. While the 12-month primary surplus/GDP ratio as of August stands at 1.8%, the 2011 primary surplus target of 1.1% appears bound to be revised upwards. Hence, while a level below 3.1% for the actual primary balance to GDP ratio by the year-end would imply the usage of an expansionary fiscal policy in the year 2011, a difference of at most 1.9% between the neutral primary balance to GDP ratio and the actual primary balance to GDP ratio would make us conclude that at least no “fiscal impulse” has been applied.

Undoubtedly, how the TRL13.5bn revenues projected for the current year from the public receivables restructuring plan (1% of the GDP) or the improvement in primary expenditures (whose magnitude we are unable to precisely estimate at this point) via a reduction in budgetary transfers through social security institution (SGK) premium collections are included in the analysis are also crucial. (The plan in question envisages additional revenue collections of TRL10.3bn (2012); TRL8.6bn (2013); TRL3.1bn (2014); and TRL1.0bn (2015)). While such revenues, given their one-off nature, might be excluded from the scope of the analysis to reveal the actual performance, conversely they might be maintained on the premise that they amount to the depletion of an accumulated receivable inventory. For example, in the programme defined data issued for the budget, the Treasury Undersecretariat makes adjustments for one-off items such as privatisations and public banks’ profit transfers, while making no adjustments for related collections. Moreover, the delivery of tax and premium payments to the Finance Ministry and the SGK initially has a contractionary effect on household disposable income and hence in this way amounts to a contractionary fiscal policy. Eventually, this effect is neutralised based on the extent to which these additional revenues are transformed into expenditures.

Conclusion: Cyclical variations paramount for a realistic assessment of fiscal framework... Turkey is one of the few countries to have implemented exit strategies from expansionary fiscal policies in the aftermath of the global crisis. This has helped Turkey rank favourably on a global scale in terms of fiscal balances and indebtedness indicators. However, adjusting for the cyclical variations induced by high growth, the resulting picture indicates that in fact expansionary fiscal policies have not been completely discontinued, and that fiscal impulse remained in use in 2010, albeit to a minor degree. While this stance observed in the past two years has failed to stem the deterioration in the C/A deficit, it has also narrowed the manoeuvring space for counter-cyclical fiscal policies. Hence, we believe it would be appropriate to evaluate the fiscal framework to be laid out in the medium-term programme not solely on the basis of budget targets, but with an approach that takes cyclical variations into consideration, and hope our study would help investors to this end.

Annex: Methodology for Fiscal Impulse Calculations The fiscal impulse is calculated as the change in the fiscal stance between two consecutive years, which in turn is calculated as the difference between the actual and a cyclically neutral fiscal balance. The first step in the process is to estimate the fiscal stance:

FS = (T – G) – (T* – G*) (1)

where T and G refer to actual revenues and expenditures in the current year, and T* and G* to cyclically neutral revenues and expenditures (all as a share of GDP). T* and G* are from a base year when actual output was at its potential, with two additional assumptions: (i) T* remains constant and (ii) G* remains constant only as long as actual growth equals potential growth. In the case that actual growth is greater than (less than) potential growth, G* falls (rises). For the present exercise, potential GDP growth was assumed to be the average annual growth rate over the past 20 years.

The fiscal impulse is the change in the fiscal stance in (1), multiplied by negative one (to indicate that a weakening of the fiscal stance imparts a positive fiscal impulse):

FI = (ΔG – ΔG*) – (ΔT– ΔT*) (2)

The first term in the fiscal impulse captures an increase in the spending to GDP ratio above what would occur if spending rose at the rate of potential output. The second term is equivalent to the change in the revenue to GDP ratio, since by assumption T* is held constant. Thus, the fiscal impulse, on the revenue side, simply reflects changes in actual ratio of revenue to GDP.

Source: IMF, Regional Economic Outlook: Western Hemisphere, November 2006

Interventionistas

The scheduled August MPC meeting could be an opportunity to revert to a wait-and-see mode, while monitoring critical events concerning EU debt problems… The interim MPC meeting on August 4, along with the decisions taken then and later would normally have rendered the scheduled August MPC meeting a non-event. However, stability still remains elusive, with financial markets largely prone to event risk. Moreover, our Central Bank is shy of pronouncing a clear outlook for inflation and growth; rather, they opt for presenting two alternative global scenarios, given the elevated uncertainty, and clearly aim to buy time to make healthier decisions, going forward. In our view, the pre-emptive u-turn in monetary policy has been presented as a means of containing the downside risks for our economy, given the state of the global economy, but it was purely a verbal intervention to the growth perceptions of market players. Therefore, the CBT’s view still has to be tested with macro data, while it seems that the intervention has served to temper growth expectations. This is seemingly helping the CBT set the playing field, as overheating arguments and C/A concerns might be taking a back seat.

The CBT, guiding for its next monetary policy moves, has become markedly vocal on the value of the TRL against hard currencies, in a bid to engineer a soft landing... In order to predict the next move, we should know the scenario to which the CBT is currently attaching greater weight. In the first scenario, in case of concrete and satisfactory solutions to recent European debt problems, the CBT expects a rapid appreciation of the TRL, along with commodity price increases. In the framework of this scenario, the CBT would have to keep the RRR high and the policy rate low, in order to avert hot money inflows. Moreover, tighter measures to curb loan growth, such as a marginal reserve requirement, speed limit to borrowings, and restrictions to leverage ratios would be necessary. In the second scenario, featuring a delayed and dissatisfactory solution to recent problems, the CBT expects further TRL depreciation and envisages greater risk of a recession. Therefore, the RRR on TRL liabilities might be reduced gradually or aggressively, depending on the extent of the slowdown in that scenario. However, in both scenarios, the CBT leaves the door open for measured policy rate cuts, while underscoring that this would not necessarily be in the form of a series of rate cuts. On the other hand, at his recent interviews in some local TV channels, CBT Governor Basci sounded more hopeful about a resolution to EU debt problems: probably the mood change was related to the FOMC meeting dated August 9, where the FED expressed a commitment to hold FED funds rate at current low levels at least till mid-2013, while opening the door to QE3, as well as ECB secondary debt market buying Italian and Spanish bonds. However, the MPC is likely to remain cautious about the repercussions of financial shocks for the domestic economy, until it gets clearer signs of an improvement. For the time being, this would imply that the CBT still ascribes a higher possibility to the second scenario, as the root causes of global jitters -- record high Italian and Spanish yields -- were the sole trigger for the interim meeting, although the CBT Governor sounded otherwise recently. However, we think the current slight tendency in favour of the latter scenario is conditional and susceptible to data and event evolution.
Accumulating downside risks could trigger more drastic downward revisions… Globally and locally, growth view will hinge largely on short-term economic activity, domestic demand, and leading indicators, going forward, since downside risks are accumulating, as recent macro data releases have generally produced negative surprises. More importantly, this could trigger significant downward revisions to GDP forecasts and confirm the recent trend in stock markets.

Consecutive slumps in stock indices and the sharp retreat in bond yields prompt the perception that, more than a slowdown scenario, it is the scenario of a recession in the global economy that is being priced in... The foremost -- and as yet perhaps the single -- factor to support this perception to date is a key leading indicator, the Purchasing Managers Index (PMI), which has edged closer to the critical 50 threshold, considered to separate economic growth from contraction phases. Past data suggest that nearly each time that the index in question has dipped clearly below the 50 mark (levels at and below 45); an episode of economic contraction has ensued. Moreover, as growth has failed to gather adequate momentum despite quantitative easing programmes launched in developed economies and bail-out packages aimed at debt-stricken countries, overall sentiment has faltered, undermining hopes as to the effectiveness of potential additional measures. In case of a lack of developments to assuage these concerns and the persistence of risk aversion, we could evidence more dramatic declines in consumer and real sector confidence, and the risk of a negative feedback loop could increase notably. While such risks have started to become factored into market prices, they are yet to be duly reflected to economic forecasts. Such changes in global economic outlook will clearly have adverse ramifications for the Turkish economy, though the extent of the impact remains critical. Given the marked uncertainties concerning global economic outlook at this stage, we have opted for a scenario-based approach to come up with estimates for economic and financial aggregates for the near future. With this purpose, while maintaining our estimates in the framework of our baseline scenario for 2011-2012 despite accumulating downside risks, we add two further scenarios: i) “soft landing”; ii) “mild recession”. The scenarios include our estimates regarding the values other economic and financial indicators may take on the basis of quarterly and annual projections for GDP growth until YE12. Whilst forming our GDP estimates, we made assumptions regarding qoq changes in seasonally-adjusted GDP data, the primary indicator for the growth trend. For example, we assumed in the framework of our baseline scenario that there would be no change in growth in 2Q11 vis-à-vis the prior quarter of the year; that sub-potential growth would be registered in the subsequent three quarters (0.5%, 0.9% and 0.8%); and that once again above-potential growth would be recorded in the remaining three quarters (1.8%, 2.1% and 1.2%) until YE12. In this respect, our GDP growth estimates for 2011 and 2012 are 6% and 4.5%, respectively.

Our more negative alternative scenarios include our estimates as to the values growth rate may take in case of a series of flat/declining seasonally-adjusted quarterly GDP readings. In both scenarios, while the 2011 growth rate does not change substantially with respect to the baseline scenario, the effect is evidenced most notably on the 2012 growth rate. Even in the soft landing scenario, annual GDP change becomes 2.5%, undershooting the 4.5-5.0% range considered as the potential growth rate for the Turkish economy. This notwithstanding, even in the worst-case scenario that we envisage at this point, we do not expect the Turkish economic growth to slip to negative territory; i.e. contract, on an annual basis in 2012, even though we do not rule out quarterly contractions (Table 1). Our opinion is underpinned by technical, as well as fundamental reasons. The technical reason is that, the slowdown, which has deepened due to negative shocks, is poised to show its impact as of the latter half of the year, and this factor will diffuse the deceleration in growth to a two-year time frame. The fundamental reasons, on the other hand, are key factors such as the absolute and comparative relief provided by Turkey’s indebtedness indicators, and the soundness of the banking system, as well as the ability of the Central Bank and the government to resort to counter-cyclical monetary and fiscal policy moves in case of necessity.

Moreover, the CBT’s guidance on growth was not very negative for 2H11. Governor Basci pointed out that qoq changes in seasonally-adjusted GDP would be flat in 2Q and would be slightly positive in the remaining quarters. In other words, the CBT’s projections were not much different from our base-case scenario. However, they probably see downside risk to their forecasts, especially for 3Q and 4Q, since the measures adopted on August 4 have been presented as a means of containing the downside risks for our economy. As technical recession occurs when the level of real gross domestic product (sa) declines over two successive quarters, the CBT will consider this risk seriously and act accordingly. Let us remind you that even in the Eurozone, the epicentre of global financial tensions, GDP growth showed a positive, albeit small, change in 2Q.

All in all, given the limited time frame since the interim meeting and the persisting uncertainties regarding global economic outlook, we think the CBT should return to a wait-and-see mode to monitor the critical events related to EU debt problems. Given that the President of the European Council is assigned to make concrete proposals (to improve working methods and enhance crisis management) by October the earliest, we do not expect any rapid solutions in the near future. Therefore, the CBT is likely to tend more towards the pessimistic scenario; thus looks set to maintain an “easing” bias. However, this does not necessarily mean an imminent further easing at the scheduled August meeting. Although, we do not rule out another measured (25bp) policy rate cut, this is not our central view. Nor do we expect an RRR cut on TRL liabilities for the time being. Please note that even in our base-case scenario, we foresee around 200bp cut in RRR on TRL liabilities till the year-end.

The TRL may benefit in the short-term from a pause in easing, but this would be temporary, since the “easing” bias appears poised to be maintained. Hence, there will be a need for further verbal interventions (Governor Basci said they reckon the TRL basket should be 5-10% lower) and prevailing facilities (regular FX selling auctions, decrease in RRR on FX liabilities, US$10.8bn CBT FX deposit facility to banks) providing FX liquidity. Furthermore, the CBT could leave its FX selling unsterilized, meaning not compensate for TRL liquidity withdrawal and let the secondary market repo rates climb to the upper (PD at 8 %) limit to support the TRL against hard currencies. Other key factors to support the TRL might be 1) The 27% depreciation of the TRL against EM averages (Graph 3) since the beginning of 2010 on the heels of the CBT’s new monetary policy implementation; 2) The CPI-based real effective exchange rate index slipping remarkably below its long term averages, and becoming only 10% overvalued against the index with base-year 2003 (Graph 4). (REER against EM countries 8.6% undervalued, REER against Developed countries 18% overvalued, PPI-based REER 6.8% overvalued and unit labour cost based REER 20% overvalued) You might notice that none of the official indexes other than the REER against EM supports the Governor’s argument about the TRL’s undervaluation.

On the rates, we still see a downside potential for the benchmark bond yield, despite around 1pp fall since the August 4 meeting. We expect bond yields to trade within the 7.0-8.0% range in the coming months, due to non-residents’ ongoing quest for higher yields. We reckon that the historic trough of 6.88% (Jan’11) could be tested again, but only in case of benign CPI prints.