Monday, January 26, 2009

Weekly Hurriyet Column: Deconstructing three myths

Below is the unedited version of my column for this week. You can read the final version at Hurriyet's authors archive. A few additional points are in order: For those of you verse in Turkish, Salih Neftci had an interesting article on CDSs today. While he briefly defines the animal, which I was not able to do due to space constraints, if you want to know everything about CDSs, I can refer you to a set of excellent posts at Charles Davi's blog. Also, I recently came across a great short piece in the Economist that illustrates why econometrics should be handled with care. Finally, the IMF paper I am referring to is here.

As JFK once said, the great enemy of truth is often the myth. Therefore, for the noble quest for lux et veritas, I would like to devote this week’s column to deconstructing three myths of the Turkish economy.

First, the December budget figures leave no doubt that there is significant fiscal slippage. However, just as fiscal-hopefuls are well off the mark, so are those attributing the figures to expansionary policy. In fact, while the December turnout reflects the rise in primary expenditures, which have never been a strong point in Turkey’s fiscal report card, even more noteworthy is the slowdown in tax revenues. The tax system’s sensitivity to domestic demand is proving to be useful for once, as the December revenues, along with other recent leading indicators such as November industrial production and December capacity utilization, have already prepared me for the shock when the fourth quarter growth figures will be announced on the last day of March.

Monetary policy has similarly been of use in an unexpected way. While we have yet to see how much the Bank’s recent aggressive easing will make its way into the economy, it has at least hopefully dispelled the ultimate myth of Sisyphus: The high interest low exchange rate myth, i.e. the urban legend that the Bank has been targeting the level of the exchange rate. In addition, the lower policy rates and the easing bias that has come with them have earmarked the continuation of the bond rally that has been going on since the fall of last year, a rally that has happened despite the weakness in the lira in the same period.

While the noted decoupling between the lira and Treasuries partly reflects the global environment and is in no way exceptional to Turkey, it is curiously expected to continue, as most market economists are noting that there may still be some value left in Treasuries, while at the same time shifting their USDTRY trajectories for 2009 upwards. Maybe, a first step towards understanding this interesting enigma is noting that both the lira and interest rates are influenced by many factors, only some of which are common to both.

To illustrate, a recent IMF paper has found disinflation credibility and the risk premium as the main determinants of real rates in Turkey. While such empirical analysis should always be handled with care, I had reached a similar conclusion around the same time (see the October 8 entry in my blog). The downward trend in inflation expectations and the sharp fall in credit default swaps (CDSs) from December to early January fit in well in this respect.

While CDSs are all-encompassing market-based measures of risk that tend to move together, there are certainly important Turkey-specific factors that could easily cause a jump in the perception of the country’s risk premium- for a case in point, just have a look at the Turkey and Ukraine CDSs for the past year. I had already discussed in previous columns the possibility of a fiscal binge, crowding out from the Treasury’s borrowing program and external financing woes in the absence or delay of an IMF program. Just add in mounting real sector troubles and rising political tensions to fully appreciate the richness of Turkey’s risks.

JFK noted that belief in myths allows the comfort of opinion without the discomfort of thought- at least before the house of cards comes tumbling down, when it is too late to think anyway. So do some thinking and worrying in advance, and Turkish Treasuries may suddenly stop being the great value they are marketed to be.

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