A Much-Needed Window of Opportunity for Central Bank Policy: Analysis

SONER KISTAK

In the last two years, Turkish interest rates have been at the center of numerous debates ranging from international politics to monetary policy, from local elections to macro policy, and food inflation to Trump tweets.

These happenings were even the subject of theoretical discussions between monetarists and neo-Fisherist proponents.

Following the principle of Occam’s razor, i.e. “the simplest explanation is usually the right one,” we can avoid this noisy, complex discussion and relate interest rates to a single actor: Turkey’ ability to attract foreign inflow.

As a country that has had an average current account deficit of -5 percent over the past decade, Turkey is heavily dependent on attracting hot money to cover its financing needs.

Since this is a deep-rooted structural problem that is unlikely to go away anytime soon, we can safely assume that Turkey’s relative interest rates will be a key consideration in attracting capital from the developed world.

In other words, it is not only Turkey’s absolute interest rates but also those of other countries that are important in this equation.

The following anecdotal example from Japan is useful in explaining the dynamics regarding recent inflows to Turkey. In July, Japanese investors showed a renewed interest in Turkish bonds simply because the lira-denominated assets offered very attractive yields.

Even though Turkey is seen as high-risk, a 15-percent yield in lira terms is still very attractive for Japanese fund managers who obtain negative yields from their own country’s 10-year government bonds.

Therefore, fund managers who are in search of higher interests prefer emerging countries like Turkey, Brazil, South Africa, etc. Moreover, Turkey’s real rate remains above average compared with its emerging-market peers. As we all know, Japan has been suffering from low interest rates and a deflationary context for almost two decades.

Unfortunately, there are now uncomfortable signs that point towards European economies likely suffering from the “Japanification of their economies.”

The existence of this symptom in Europe can be best observed by looking at the current -0.40 percent European Central Bank (ECB) deposit facility rate. The appointment of Christine Lagarde as the ECB governor will only mean the continuation of Draghi’s policies and therefore low interest rates.

The table below shows the Bloomberg-based forecasts for the interest rates in different regions and countries. The first observation is extremely low interest rate forecasts for developed regions like the Eurozone and the United States.

In Switzerland, for instance, the 10-year bond yields are forecasted to remain negative in 2020. This low interest rate environment has some beneficial consequences for emerging market countries like Turkey.

How so? Institutional investors from developed markets in pursuit of higher yields and cash flows are more willing to invest in Turkish assets to take advantage of higher interest rates.

This means that Turkey is likely to find easier financing, particularly from Europe, during the next two years than it was able to during the last two years.

Secondly, we observe that compared with other emerging market countries like Brazil and South Africa, the Turkish interest rates are likely to remain relatively higher, thus increasing the attractiveness of Turkish fixed income instruments.

The deflationary context in Europe and Japan will likely bring about a window of opportunity where the Central Bank will be able to decrease interest rates without hurting Turkey’s ability to attract inflow ceteris paribus (all other things being equal).

From a purely financial perspective, we will probably find a friendlier context in the next two years. (For example, during the U.S. Quantitative Easing 2009-2012 period, Turkey was one of the beneficiaries.)

At the same time, we should note that we should seize this opportunity to carry out the necessary reforms to reinvigorate the country’s economic dynamics.

With good communication and prudence, Turkish economic policy can help the country reinvent itself. Hopefully, we will move away from a “borrow and spend” mode and towards a “produce and save” mode.