Interest rate cuts will not have much influence on growth rate unless the upper limit of credit growth rate is increased.

Assume that Turkey wants to enhance growth rate. Which option do you think it must go with: to lower interest rate while keeping credit growth rate constant or to raise credit growth rate slightly?

The Central Bank of Turkey has been allowing short-term interest rates to drop significantly since July. Currently short-term interest rates float below the policy rate at 5.75 percent and slightly above the lower limit of the interest rate corridor at 5.5 percent. On the other hand, interbank interest rates on average were 9.5 and 9.7 percent, respectively in the first and second quarters of the year. Short-term interest rates therefore dropped radically.

Source of finance

For many market economies, it is the changes in credit supply rather than those in interest rate that influences growth more. For example, in the US interest rates are significantly low, but the Fed has been trying to boost the credit market since the beginning of the global crisis. Similarly, research on Turkey reveals a strong positive relation between credit growth rate and economic growth rate.

There is no puzzle here: even if you keep interest rates low, people planning to make investment or consumption will need finance to fulfill their plans. Obviously, the finance requirement does not apply for consumption on basic goods or investment on hammer and nails. But it applies for genuine investment expenditures, spending on durables and on real estate. In the case for Turkey, bank loans are the chief source of finance.

For almost two years, officials have been stressing that for the sake of financial stability, bank loan growth rate should not exceed 15 percent. I don’t intend to discuss whether this is the right call or not. Yet, we have to note that interest rate cuts will not have much influence on growth rate unless the upper limit of the credit growth rate is increased. I am not claiming that interest rate cuts since July were completely ineffective. They were productive at some degree: for instance, if accompanied with lower deposit rates, it can promote consumption over saving and this will increase consumption for those who did not need banks loans and consumption of low-cost goods and services. At the same time, however, officials have been arguing that such increases in consumption were not desirable due to the potential current account deficit risks.

A different upper limit

Interest rate cuts might to some degree contribute to exports as it limits the appreciation of the lira. But there are some risks associated: first, the major impediment to Turkey’s export performance currently is the stagnant or weak purchasing power gains in export markets, not the value of lira. Second, provided that global uncertainties do not grow and with the upgrade on Turkey’s rating, FX inflows to Turkey will increase (is increasing already), putting an upwards pressure on the value of lira. In the end, Turkey will not earn any competitive advantage.

There is no harm in cutting interest rates as long as the inflationary outlook allows. With respect to growth performance, however, Turkey has to review the upper limit of the credit growth rate. If this sounds dangerous, it can consider studying the viability of different alternatives for certain types of loans, investment loans for instance.

This commentary was published in Radikal daily on 13.12.2012