Inflation fighting lesson

Historical retrospective: Unconventional inflation combating… Mr. Erdogan is known to have a theory that high interest rates increase inflation rather than reduce it, as economic orthodoxy does not advocate. In a recent televised interview and a private meeting with institutional investors, the president reaffirmed his stance on interest rates and declared his opposition to them. Since a monetary policy in line with this economic theory was adopted as the New Economic Model around this time last year, the lira and inflation trend have worsened.

The latest unconventional method came from Nigeria, at the beginning of November the Central Bank of Nigeria announced an unusual anti-inflation measure: the redesign of 100, 200, 500 and 1,000 naira notes. The bank believes that forcing people to exchange old banknotes for new ones will clear out the large amounts of currency stored in private vaults outside the banking system.

The new bills will be issued in December, but Nigerians have already been asked to start depositing their old bills before they become obsolete by the end of January next year. But as Nigerians try to avoid this measure and instead convert the naira to dollars, the resulting shortage of dollars further weakens the naira and worsens inflation.

Traditional policies, what does the Fed do? One of the main tools the Fed uses to stabilize inflation is to raise interest rates. This is an example of monetary policy.

The government can implement fiscal policies to reduce inflation by increasing taxes or reducing spending.

The Fed must be careful when raising interest rates because slowing the economy can put many people in trouble.

The example of Turkey... What have we done, what are we doing? Will it work? The foreign exchange (FX) liquidity problem of the Turkish economy is getting worse. So far this year, the foreign trade deficit has averaged $9 billion per month, while the trade surplus of service sectors such as tourism and transportation has not been able to meet it. As a result, the current account balance, including both goods and services trade and some income transfers, remained in the red with a monthly deficit of approximately $5 billion. Gross foreign exchange and gold reserves of the Central Bank of the Republic of Turkey (CBRT) total $114.2 billion, but in reality much less. Excluding liabilities, net reserves are only $13.4 billion. Currency swaps with domestic commercial banks and foreign central banks are widely used to increase CBRT reserves. When these half liabilities are also removed, total net reserves drop to -58.6 billion dollars. The Treasury keeps foreign currency assets in CBRT accounts and these deposits are not part of the monetary policy. Excluding them, the final net total reaches $64.1 billion, as low as it was in December 2021, when Turkey was hit by a major currency shock.

Turkey faced a similar situation in July 2022, when the constant current account deficit dried up foreign exchange liquidity and the CBRT reserves fell to extremely low levels. The government managed to prevent a new shock by restricting capital mobility even more with the new regulations made by the Banking Regulation and Supervision Agency (BRSA) and the CBRT. According to the decision taken by the BRSA, companies that are obliged to conduct external audits will be able to use Turkish Lira (TL) loans if their foreign currency financial assets do not exceed 10% of their net sales or total assets. The new CBRT regulations, called the 'liraization strategy' of the government, force the banks to buy government bonds in case the ratio of local currency assets to the total decreases, despite their much lower returns than the current and expected inflation rates. is intended to sell and then deposit the money into foreign currency-protected TL deposit accounts. These accounts provide Treasury and CBRT guaranteed returns equivalent to the appreciation of the dollar, euro and sterling against the lira. With this deposit inflow, the CBRT protected its reserves and prevented a possible exchange rate shock.

These adjustments were revised in October 2022 given the risk of an imminent currency shock. With the FX asset ceiling lowered from TL 15 million to TL 10 million, almost all companies now had to sell their FX holdings in order to access cheap bank loans in lira. Banks are also rushing to buy local currency government bonds, which yield around 10%, while dollar-denominated government bonds yield even higher. In addition, taxes on corporate FX income gains are exempted until the end of 2022, provided that companies convert their FX assets into FX-protected deposits.

Turkey, which has a short-term external debt of 185.9 billion dollars and whose current account deficit is expected to remain around 40 billion dollars until the elections, is in great need of foreign currency. The CBRT's reserves are insufficient and, as a result, capital constraints are imposed to force businesses to convert their FX assets into FX-protected debt. This mechanism works well enough to maintain short-term stability in the currency markets. But the main goal is to win the election, and this will require more economic dynamism. Open spending and cheap loans from state banks are the main tools at the government's disposal. The CBRT's policy rate has already fallen to 9% and will remain at these levels for a while. The most important side effect of all these policies is the increase in demand for foreign exchange assets.

In order to meet this demand, unregistered capital inflows have been encouraged since the beginning of the war in Ukraine. In the first eight months of the year, the CBRT's balance of payments statistics show a total of 28 billion dollars in “net errors and omissions”. Although the source of these entries is unknown, they may represent Russian citizens and legal entities that bring their foreign currency and gold assets to Turkey. The U.S. Department of the Treasury's Office of Foreign Assets Control (OFAC) has warned the Turkish government and business chambers of concerns about the entries and possible sanctions risks. The use of the Russian credit card system Mir by all banks operating in Turkey was also suspended after OFAC announced that it had violated the sanctions. These developments will reduce future unregistered entries; however, the Turkish government is currently negotiating with its Russian counterpart on extending payments for natural gas imports. This does not violate US sanctions, and if Russian President Vladimir Putin and Turkish President Mr. Recep Tayyip Erdogan comes to an agreement, there is no direct means to stop it.

Will Turkey have to raise interest rates? What happens if we increase the rate, what happens if we keep decreasing or not increasing it? Turkey's rate cut series continued at the meeting held on Thursday last week, in an environment of Mr. President's call for the policy rate to fall to single digits despite inflation rising above 85% this year.

The monetary policy committee has reduced the benchmark rate by 5 points cumulatively since August, bringing it to 9%. Many economists expect the policy rate to continue at this low level for a while, as the Central Bank's clear reference.

The gpvernor of the central bank, Mr. Şahap Kavcıoğlu acknowledged failing to curb inflation, but said he expects price growth to peak this fall after hitting the highest level in a quarter of a century last month.

President Recep Tayyip Erdoğan evaluates that the extremely loose monetary policy should continue in order to stimulate the economy before the elections to be held next year. Erdogan, who describes himself as an 'enemy of interest', believes that, contrary to mainstream economic theory, high rates feed inflation rather than slow it down.

The growth policy at all costs has dealt a blow to the lira, which has depreciated by about 43% in one year against the dollar. After a series of interventions by the central bank and government policies, the lira has stabilized in recent months.

Turkey's real interest rate adjusted for inflation, at minus 75%, is among the lowest in the world. Haluk Bürümçekçi, the founder of Bürümçekçi Research and Consultancy, said that many economists no longer care about the policy decisions of banks and they rely on other interest rates such as deposit rates of private banks that act independently of the indicator: “It doesn't matter if it is 10.5% or 9%”.

Conclusion? The economic policies the AK Party needs to win the elections in June require more foreign exchange reserves. Capital restrictions will help protect the currency already in Turkey, but more will be needed. Russia is a potential resource, either unofficially or through official lines of credit with Gazprom, Russian state banks or the Central Bank of Russia. No agreement has yet been reached, but Putin's proposal to make Turkey a gas hub could be interpreted as a step towards further strengthening bilateral economic ties.

If no funds come from Russia or another country or investor, Turkey's expansionary economic policies will lead to a new foreign exchange shock. Turkey ranks only slightly above Pakistan, Egypt and Tunisia in international credit ratings due to growing concerns about its ability to make timely foreign currency payments to bondholders and importers. In August, Moody's downgraded Turkey's sovereign credit rating to B3, the lowest ever, while S&P and Fitch rated the country's credit rating as B, the second lowest in its history. Although the rates were worse in the 2001 and 2008 crises, the Turkish Treasury's credit default swap premium for government debt instruments remained around 700, which is a really high level, and has recently improved slightly to below 600 basis points.

Turkey's financial stability and industrial production will likely continue until the beginning of 2023, at which point generous economic policies will begin to strain both production and demand. For this strategy to be successful until the June elections, more foreign exchange resources will be needed. The amount and timing of these resources will play a key role in assessing the 2023 outlook for the Turkish economy and predicting the June election results.

Kaynak: Tera Yatırım-Enver Erkan
Hibya Haber Ajansı