Government facing unpleasant options

This week's turmoil in the financial markets woke us from an early August torpor. First there was a limited increase in the exchange rate, then the Turkish Central Bank decided, unexpectedly, to increase the upper limit of its interest corridor by 50 points, followed by a limited but significant shock in the exchange rate on Wednesday, along with good news from the US economy on the strong housing demand. Finally on Thursday, while I am writing these words, the drift of the Turkish lira continues after the release of the Federal Reserve's July minutes implying an earlier than expected halt to its loose monetary policy. Admittedly, the central bank's reaction was not convincing.
On July 15, I wrote in this column (“Relax until autumn”) that, based on Federal Reserve Chairman Ben Bernanke's testimony to Congress, the restrictive monetary policy would not start before autumn. I was mistaken. The hour of truth came earlier. Everybody, from the managers of the economy to the investors and even to simple citizens, were perfectly aware of what would happen in the near future. First, the Fed would gradually cease its purchases of assets from the market, in this way ending its quantitative easing policy that flooded financial markets with trillions of cheap US dollars in recent years, and then the Fed would abandon its zero interest rate policy if the US economy were definitely past the risk of recession. It was also well known that changing the Fed's monetary policy would cause outflows of capital, particularly from emerging economies suffering from chronic current account deficits, such as Turkey. It seems that this new international scenario is now under way, perhaps earlier than expected. Since what would happen is common knowledge, the question is what policy reaction must be made in this new international setting to counter a fully fledged exchange rate and interest rate shock in order to avoid a recession. In my article of June 17 I questioned whether the Turkish economy was on the eve of recession. My answer was “Yes,” if the government did not abandon the conspiracy theories around the infamous “interest rate lobby.” Since then, these theories have fortunately disappeared from the discourse of Prime Minister Recep Tayyip Erdoğan, but it is still not certain that the central bank is fully independent in setting its monetary policy. Just before the recent turmoil started, Deputy Prime Minister Ali Babacan declared that the measures to be taken against the consequences of the expected Fed policies were ready, without describing them explicitly. We can guess that pursuing fiscal discipline, in other words maintaining low budget deficits, is part of these measures. Indeed, in an economy where there is a high current account deficit and which is moreover obliged to finance the biggest part of this deficit with portfolio investments and bank loans, fiscal discipline constitutes a precious anchor but it is not, unfortunately, enough to prevent capital outflows and the drift of the Turkish lira. The value of the currency basket reached 2.30 on Thursday, meaning a depreciation of 15 percent compared with May. Obviously, the recent increase by 50 points of the upper limit of the interest rate corridor, now standing at 7.75 percent, has not been sufficient to calm the appetite for hard currency. I must note that the effective interest rate used by the central bank when giving liquidity to the banking system stays below 7 percent, while the market rates are now close to 10 percent. So, the central bank began to use its reserves again through the daily sale of hundreds of millions of US dollars. A number of economists, including myself, have the impression that the Turkish Central Bank is still under political pressure, since it cannot use its main instrument, the policy interest rate. The more the Turkish lira depreciates, the more inflationary pressures will increase. The central bank cannot maintain its interest rates at their current level in these circumstances. Are there other measures? I do not think so. Certainly, it is possible to let the Turkish lira depreciate until it reaches a sustainably low value. This could help to lower the current account deficit, and then capital inflows could begin again, but this will be at the expense of economic growth in the short term. In this case, the economy risks entering a temporary recession, and then a new equilibrium could emerge from this if an increase in inflation cannot be prevented. Nonetheless, I do not believe that this is a policy option for a government that will soon face a series of elections.