Fears of recession and contagion

While I was surfing the Internet this morning (Friday), trying to get recent information and the latest on economic events before discussing the probable consequences of the recent tightening of Turkish monetary policy, I discovered a column written by Paul Krugman, the Nobel Prize-winning American economist, titled “Talking Troubled Turkey.” Krugman seems quite concerned about the current state of the Turkish economy.
Paul Krugman concerned by Turkish economy He argues that in case of “a sudden stop,” i.e., a stop in short-term capital inflows from abroad, a recession cannot be avoided in Turkey. Then the contagion risk to other weak countries would be very serious, given the weaknesses of Western economies that make “these troubles scary.” Finally, the whole world economy might end up in a mess triggered by a Turkish crisis, as happened at the end of the 1990s in East Asia and in the recent past in Europe because of troubled Greece. Krugman is right. In the case of a sudden stop, the Turkish economy could go into a recession caused by a continuous depreciation of the Turkish lira. As for the contagion, I will leave it to you to agree or not with Professor Krugman, who has more authority than I do on the matter. So, the critical question is, does the risk of a sudden stop remain, despite the interest rate increases decided by the Turkish Central Bank on Tuesday evening? Before trying to answer this critical question, I would like to reiterate, once again, that without this decision a recession was absolutely certain. I have already explained the reasons many times in this column. I do not want to exhaust my limited space repeating them, but will just mention the statement of Murat Ülker, chairman of Yıldız Holding, which owns food manufacturer Ülker. Ülker is also a person who is very close to our prime minister. On Thursday, Mr. Ülker declared, “I would have never thought that I would be waiting for the interest rate decision and be happy to see an increase.” Since Wednesday, the USD-Turkish lira parity has gone below 2.30 while it was pushing 2.40 before the dramatic interest rate decision. But the exchange rate is still very volatile and there is no clear signal regarding a trend of appreciation. Since Dec. 17, the date the probe scandal became public, the Turkish lira lost 12 percent of its value. This loss must be added to the loss of 8 percent that occurred since last June. Thus, the overall depreciation of the local currency reached 20 percent. Even if the current level of the exchange rate, say at around 2.26, is maintained in the coming weeks, disastrous consequences for the economy cannot be avoided. The balance sheets of the Turkish companies having high debt denominated in hard currencies will be dramatically deteriorated. This is very bad news for investment. Furthermore, the inflation forecast of the central bank, recently revised from 5.3 percent to 6.6 percent, will still be out of reach, since the pass-through from import prices to inflation will be much higher than what the central bank assumed when making its new forecast. This means that the actual level of the central bank policy rate at 10 percent would not be enough to encourage capital inflows, in other words, to avoid a sudden stop. At first glance, the recent interest rate increase seemed to be quite harsh and thus sufficient to revive the appetite for assets denominated in the Turkish lira. In fact, the interest rate increase has not been that harsh. The bottom line of the story is that the cost of the liquidity given by the central bank rose from 7.75 percent to 10 percent. This new level of the basic interest rate pushed up the expected real interest rate from zero to 2 percent, since the inflation expectation in the last survey is close to 8 percent. Nevertheless, the expectations may rapidly worsen if the Turkish lira does not appreciate to some extent in the near future. Admittedly, political uncertainties as well as the discourse of the prime minister about the place of the interest rate in an open market economy, a discourse that defies the basics of economic theory, caused significant damage in terms of confidence with respect to economic governance. The central bank cannot reverse the threats the Turkish economy is facing alone. A few days ago, government officials started talking about Plans B and C, Plan A probably being the recent move by the central bank. We don't have enough details to comment on these later plans, but it seems that new rules about corruption are envisaged as well as incentives for foreign capital. We'll see. In the meantime, Turkey will continue to give Mr. Krugman some shivers.