Monday, July 20, 2009

Weekly Hurriyet Column: Of Mrs. Tasimasu’s watermill and 007

Below is the unedited version of my column for this week. You can read the final version at Hurriyet's authors archive. Just a couple of quick comments: First, I know that the title is really cheesy, but I just couldn't pass on the opportunity. Second, for those of you who speak Turkish, the Turkish translation of knockoff is "cakma". I had to think a lot to come with the right word, and I think knockoff is the closest match.

Every Japanese kid knows the story of Mrs. Tasimasu, who lived in a remote village in northern Japan and tried running her watermill by hauling water from the nearby lake when the river went dry.

No, not really! The title is a play on words with the Turkish proverb tasimasuyla degirmen donmez, which roughly translates as a watermill can’t be turned with haulage. This is exactly what the government has been doing with the latest tax hikes in tobacco, tourism and fuel.

Knockoff fiscal measures

Economists do not like indirect taxes for their distortionary effects of reducing welfare and increasing inequality. However, in the Turkish context, it could be argued that the government is trying to put its fiscal books back in order and getting ready for an IMF agreement. Such an argument loses on several grounds.

For one thing, the impact of the tax hikes will be limited. This is because in a crisis environment, people start cutting down on other expenditures even when you raise taxes on "necessary" items such as tobacco and fuel. Overall, I have penciled in a revenue increase of 0.6-0.7% (of GDP) as a result of the latest measures under a very optimistic scenario. Incidentally, this amount is more or less what the inflationary impact of the measures, spread over this month and the next, will be.

Moreover, even a casual look at last week’s June budget figures reveals that the fiscal deterioration is mainly coming from the expenditures side. In that sense, tax hikes will have only limited impact in putting the budget books back in order. As for the IMF implications, I wouldn't try to get too much out of the last two week's measures such as the hiking taxes, putting a stop to being nutcases on nuts and limiting wage increases; they could also mean that the government is trying to do it alone with knockoff fiscal measures.

On a more philosophical level, decreasing taxes in certain sectors and increasing in others is remnant of a bygone era in industrial policy. Such an approach was in vogue for a while, due mainly to the success of South Korea in implementing this strategy of handpicking sectors, but it is now widely accepted that this is not the way to go, even if the measures are temporary.

The Goldfinger approach to interest rates

But one thing such knockoff measures will do is to provide a false sense of fiscal responsibility, which will be supportive of Turkish assets, especially bonds, for a while. In fact, there are other rate-friendly factors in the short run, which are likely to provide resistance to yields from creeping higher in the near term.

For example, while the relative easing of liquidity conditions of late has taken them off the spotlight, nonconventional monetary policy measures I outlined last week could kick in anytime, presenting an opportunity for a rates rally. Similarly, despite a hefty redemptions schedule, primary surplus is likely to be high due to seasonal factors next month. Besides, with nearly 20 billion liras of deposits in its coffer, the Treasury could easily opt for a lower rollover ratio if there is a sell-off ahead of the auctions.

Once these factors fade away, bond-killers such as the end of the Central Bank easing cycle, banks’ high funding costs, fiscal irresponsibility and negative inflation surprises are all likely start kicking in. I would pay extra attention to October, when the Treasury faces heavy redemptions early in the month after an easy September. But I am sure the government would not want nasty surprises on the dawn of the IMF-World Bank meetings in Istanbul.

Then, without and IMF agreement or another wave of risk-induced gold rush to emerging markets, I expect you to die, Mr. Bond…

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