When a rise in interest rates is growth-friendly

ANGELO SANTAGOSTINO

Since the beginning of May 2013, as a secondary consequence of the Gezi Park issue, the Turkish lira has come under pressure. Devaluation has accelerated since mid-December, again as a secondary consequence effect of the on-going anti-corruption investigation.

The Turkish lira’s exchange rate to the euro was at 2.31 at the end of April last year. It then rose constantly until reaching 2.70 by the end of August. After a period of relative stability, the devaluation increased after 25th November. A similar trend occurred with the U.S. dollar. The pressure on the Turkish lira was already high before these two events. 

In this same period, discussion of monetary policy and the interest rate continued between pundits and economic commentators. Actually, it was more a sort of monotone discussion, as the general mood was in favor of a tightening of monetary policy. Interest rates were judged to be too low compared with both the internal and international situation. The IMF also suggested a rise in interest rates.

Despite these views the Central Bank of Turkey has kept them unchanged for long time, to help growth; this was the justification, until the abrupt recent hike. 

The crucial point is that, low real interest rates (those we obtain once the inflation rate has been subtracted) are not always growth-friendly, more precisely they are growth-adverse. Actually, interest rates are a variable which has to be adjusted to changing economic situations. This makes monetary policy a complicated and difficult issue requiring high profile technicians to deal with it. According to an old saying: money is a too complicated an issue to leave it in the hands of the politicians. 

Recently, during the crisis in America and Europe, both the Fed and the ECB have adopted a permissive stance of monetary policy to cope with the situation. Low interest rates and increase in the money supply have been thought as an important ingredient for a strategy bound to revitalize the transatlantic economies. Also due to the sovereign debt crisis, short term funds have flown from these markets to emerging economies such as Turkey or Brazil. 

As recovery gains momentum in the transatlantic economy and financial markets are more equilibrated (in term of public bonds yield in the EU Countries and tapering implementation in the U.S.), short term capital is now returning to Europe and United States financial markets.

This flow of funds also affects exchange rates. Look at the exchange rate of the Brazilian real to the euro or to the dollar, we can find a photocopy of the trend of the Turkish lira vis-a-vis these two currencies! We therefore come to a first conclusion: the readjustment in exchange rates is because “normal times” are returning. Emerging economies, of which Brazil and Turkey are outstanding examples, are losing the “privilege” they have enjoyed in the past, due to the disequilibria of the transatlantic economies. They are no more the sole safe port for financial investors, but will have to compete with the EU and the U.S. 

Interest rates play a basic role in the selection of investments. Negative real interest rates (the ones prevailing in Turkey until these days), when maintained for a long period, have the effect of diffusing inefficiencies in the economic system. This is because when they are negative in real terms, they no longer play the role of a filter for investments. Projects with low rates of return give the illusion of being viable. Resources, consequently, are not allocated in an optimal way. Growth feeds itself with the profitability and efficiency of investment. It is from high competitiveness that enterprises have to make profits, not out of low interest rates.

Interest rates are part of the beauty case of financial markets. Their new level higher and more adequate level will make Turkish financial markets more attractive, as they are the reward for private and institutional investors. Secondly, they will stimulate the quest for efficiency. The combination of these two effects is enhanced growth.

Angelo Santagostino is Jean Monnet Professor at Ankara’s Yıldırım Beyazıt University.