Central bank facing trade-offs

Turkish Central Bank Governor Erdem Başçı did not delay reacting to low economic growth, which was recently estimated at 2.2 percent for 2012 by the Turkish Statistics Institute (TurkStat). “The central bank will continue to use all the tools in its arsenal to continue a policy of balanced growth,” Başçı told reporters after a bank meeting in Ankara on Wednesday.
Governor Erdem Başçı Başçı spoke of the need to reduce core inflation of around 5 percent by the end of the year, warning that rising inflation and a growing trade deficit could throw the economy into recession. The same day, Governor Başçı, addressing a conference organized by the Mardin Chamber of Industry and Commerce, said that a “U-turn is already apparent in the first quarter revealed by increasing imports which signals a revival in domestic demand.” He added that one should expect a slightly higher current account deficit (CAD) ratio this year over last year and gave a definition of “balanced growth” explaining that “balanced growth means a growth taking into consideration internal balance, i.e., price stability, as well as external balance, i.e., the balance of payments.” Governors of central banks are well known for their hermetic-style declarations. The above statements from Mr. Başçı could be, admittedly, evaluated in this context, but I think they reveal also some confusion in the mindset of the central bank, which is facing unpleasant tradeoffs. Let's consider at least two of them: The first trade off, a classical one, is between inflation and an increase in domestic demand. The second one is between an acceptable growth for the society and a sustainable CAD, important for the investors. Let's start with the inflation versus domestic demand issue. The yearly inflation has been estimated at 7.3 percent in February. It is quite above the central bank's target of 5 percent. This gap is the main constraint on monetary policy. The central bank will not be blamed if the year-end inflation is not getting close to 5 percent but it certainly risks loss of credibility if it is not able to curb inflation close to 6 percent since it displayed a rather bad performance on the inflation front last year. Its maneuvering space is not very comfortable. Despite low capacity utilization rates in the manufacturing sector, which authorize an increase in domestic demand, this increase should anyhow be a moderate one. The central bank is aware of this constraint since it insists on the 15 percent threshold it put on the yearly growth of banking credit volume. However, it should be noted that credit expansion has already reached 20 percent and it would be very difficult for the central bank to tighten monetary policy in the actual context of low growth. I think the main question is: Were the restrictions on bank loan expansion enough to attain the planned 4 percent growth that is based on the domestic demand? Let me remind you that the last figures show more rapidly increasing imports than exports. There is now a large consensus among economists, including Mr. Başçı, that one should not expect a positive contribution to the growth from net exports as was the case last year. Before the unexpectedly low growth is confirmed, Mr. Başçı was defending a different growth regime in which external demand and domestic demand have to contribute together. This first definition of “balanced growth” seems to have been abandoned now. The acceptance of an increasing CAD by Mr. Başçı means that despite a growth of 4 percent fully based on domestic demand its financing will not be a problem. I am not so sure. This will depend first on the strength of the increase and second on the investors' appetite to finance it. The CAD share in gross domestic product (GDP) was 6 percent in 2012, while the growth was almost fully led by net exports. This year a higher growth fully led by domestic demand can carry this ratio over 7 percent. One can admit that this will not be a drama this year, but what about next year, if the CAD continues to increase? Macroeconomic fundamentals should be kept in check if one wants to keep the investors' appetite alive for Turkish assets. Investor confidence will be key for this. Fiscal discipline constitutes the gist of this confidence. So, fiscal loosening cannot be envisaged for the domestic demand revival policy. Moreover, the central bank has almost hit the limits in the monetary loosening. “The year of balanced growth” seems instead to be the year of difficult tradeoffs. P.S. I learned after this article was sent to the editor that Prime Minister Recep Tayyip Erdoğan has declared that a 6 percent interest rate is still high and must be lowered. Political pressure on the central bank is increasing.