Monday, August 24, 2009

Weekly Hurriyet Column: Realism and its evil sisters

Below is the unedited version of my column for this week. You should be able read the final version at the Daily News website, but I could not find it (Gul, take notice please), so if you can, please email me the link:)

Since I wrote this column four weeks ago, the benchmark has stayed more or less in the 9-9.5% range, despite a very favorable global environment and the CBT cutting rates 50bp, as expected. But now, it seems that the CBT may not stop with a final 25bp cut next month. While the ambiguous tone in the one-pager accompanying the rate decision led to a never-seen-before divergence of opinion between analysts, most think that CBT will take rates to as much as 6.50% from the current 7.25%, meaning that an additional 50bp (than I envisaged in the column) may be in the cards. But the analysis I did for the column shows that this should not have a huge impact on benchmarks rates, certainly less than one for one.

Last week exposed me to realism and its evil sisters, unrealism and surrealism.

I find the latest outcries by some economists for the Central Bank (CBT) to take the policy rate to 5 percent more surreal than a Dali painting. After the Bank’s latest expectations survey, the ex-ante real policy rate now stands at 1.4 percent, a historic low for Turkey. But rates are zero, or even negative, not only in developed countries, but in emerging market peers with flexible exchange rates and inflation targeting such as the Czech Republic and South Africa (a notable exception in Brazil, which I incidentally see as closest to Turkey).

Such naïve comparisons, however, ignore country risk. Adjusting for that with credit default swaps (CDSs) reveals that Turkish policy rates do not have much more room to go, maybe another 0.5-0.75 percent or so, which is in line with expectations. And that is after noting that Turkish CDSs are low compared to the country's credit rating. But this doesn't mean much, as the low-interest camp argues that Turkey's credit rating is too harsh to begin with, an argument I would agree, if I didn't know the dismal fiscal outlook.

Assuming a 0.5-0.75 percent cut in the policy rate over the course of the next two months, after which the CBT will stay put for a while, the next step is to answer the two billion-dollar questions that are very much interrelated: How much will the rate cuts pass on to market rates? When will this aggressive easing start to affect the real economy?

To answer the first question, a variety of approaches could be employed: For example, the difference between rate expectations today and a year from now gives a rough idea on where the benchmark is headed. This approach yields a low of 9.2 percent. Calculating expectations from cross currency swaps yields a similar minimum benchmark rate. Alternatively, equating funding costs to the duration of the benchmark, or looking at yield curve expectations 3 and 12 months down the road, I end up with 9 percent.

It is possible to integrate all of these approaches into an econometric framework, taking into account global developments as well. This comprehensive approach, which takes me to just below 9 percent under a very optimistic scenario, also demonstrates that the marginal effect on the benchmark from taking the rate to below 7 percent would becomes less and less. In sum, there is some more room for policy rates, but not that as far as the 5 percent some are recommending.

Coming to the second question, if it were left to the media, credit markets have not just started to thaw, they are liquid water already. Notwithstanding the difficulty in discerning how much of the recent easing in certain credit rates is actually due to CBT actions rather than to the global easing of credit, as demonstrated by global indicators or Turkish banks’ recent ability to borrow from abroad, there is hardly a stir on the data front, which is lagging behind just a couple of weeks.

Deeper analysis darkens this rosy outlook further. Adopting a methodology developed by Roberto Rigobon of MIT, it is possible to discern demand and supply from quantity and price (interest rate) data. Although I am at early stages, results so far attribute the credit freeze to a lack of demand as much as supply. While this partially exonerates banks from countless accusations, it is a bit unrealistic to assume that lower rates will induce consumers and businesses to borrow in an environment of uncertainty even if banks are willing to lend.

I find it very amusing to see that the ultra-low real rates have led to an economic landscape of unrealism and surrealism, where optimism has replaced looking into the facts and data.

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