The combination of the first three in particular is a new phenomenon for Turkey. New and critical…

Over the past two years, Turkey made economic policy mistakes. First one was about fiscal policy: in the second half of 2010 and the first half of 2011, current account deficit that reached record-high levels constituted the main concern. In addition, the FX requirement resulting from the current account deficit was predominantly met by short term external borrowing. With these circumstances and record-high growth rates, fiscal policy was not tightened. Tax revenues picked up with the help of rapid growth, but budget expenditures also rose equally. If the rise in expenditures could have been limited, rapid growth would have decreased relatively along with a fall in current account deficit from record-high to high levels. Today, due to the weakening of growth, tax revenues are not increasing sufficiently but the rise in expenditures maintains the last year’s pace. And meanwhile, Turkey is trying to discipline its budget. To put it differently, by raising tax rates the disposable income of consumers is lowered, that is, domestic demand is suppressed in a period when policies to stimulate, at least not to reduce, domestic demand are needed to tackle slow growth. The fiscal policy was geared up in the wrong time and now it is geared down in the wrong time.

The second mistake was made in collaboration by the Central Bank (CB) and the Banking Regulation and Supervision Agency (BRSA). In order to prevent the rapid credit growth, the CB gradually increased the reserve requirement starting in the late 2010. For its efforts to pay, the BRSA should have stepped in simultaneously. Yet, it intervened eight months later the CB’s first step; in June 2011, two months before the circumstances across Europe started to worsen, automatically weakening credit growth. The BRSA’s timing was wrong for sure.

The third mistake was made by the CB: starting in the late 2010, the CB pursued a low and floating interest rate regime with the aim to increase the exchange rate and thus reduce the current account deficit and short term external debt inflow. This policy was pursued roughly until August 2011. The upwards pressure on exchange rate pushed up inflation. The intensification of the European crisis starting with August 2011 weakened the international risk appetite, causing FX outflows away from Turkey and peer countries. This coupled with the CB’s policy caused a hike in exchange rate, followed by inflation reaching two-digit levels. A policy to gradually increase exchange rate, which is a logical option under normal conditions, was employed in the wrong time; in a period full of international uncertainties. A few months after the efforts to increase the exchange rate, the CB was forced to reverse the policy and sell FX to lower the exchange rate.

The fourth one was also the CB’s mistake. With the aim to stop the upwards trend in inflation at two-digit levels, a number of active monetary policy tools were implemented starting with the end of November 2011. The Bank changed short-term interest rates on daily basis. Up until June 2012, the CB was so active that inflation reports frequently mentioned temporary, weekly for instance, monetary tightening (that is, high interest rate) in order to limit the distress about inflationary expectations. Besides allowing “notably” high short term interest rates, the CB allowed short term interest rates remain at high levels over the entire period. In a nutshell, Turkey’s growth rate decreased substantially while interest rates remained high. This also was a wrong policy at a wrong time that the CB pursued (or had to pursue).

And here is the point at which we arrived: low growth (around 3 percent) – high current account deficit (at around 7.5 percent of GDP) – high foreign fund requirement (at around 7.5 percent of GDP) – higher inflation compared to rivals (at around 7.5-8 percent). The combination of the first three in particular is a new phenomenon for Turkey. New and critical… At what rate the economy will grow from now on depends mainly on short term fund inflows. In other words, we have no option but wish that international uncertainties don’t intensify. Because if so, Turkey can grow with higher current account deficit via capital inflows. To conclude, all we can do is hope that short term capital inflows and the current account deficit that we have for long been trying to lower increase!

This commentary was published in Radikal daily on 09.10.2012