Monday, December 28, 2009

Weekly Hurriyet Column: Year of easing comes to an end

Below is the unedited version of my column for this week. You can read the final version at the Daily News website. I was too tired to come up with a cheesy title this time around. As for the article, one interesting follow-up question from a reader was on the impact of my scenario on banks: It was banking on rate cuts this year, and with that trend reversed, the obvious conclusion is that 2010 will be tougher for the banks.

It may well be, but the answer is not so obvious. For one thing, it is obvious that it won't be the bonds that are will be the driving force of bank profits, but retail. In fact, a senior retail banker friend is crossing her fingers for my scenario to materialize, as it will mean more profits for her group. As for the banks' balance sheets (and the bonds that they carry) a closer look and anecdotal evidence reveal that banks have been successful in shifting some of their load to variable-rates and inflation linkers, so they will not be as vulnerable as commonly expected to the rate hikes.

On the other hand, contrary to common wisdom, I expect credit to stall: Tight liquidity, heavy Treasury redemption schedule crowding out lending and increasing NPLs will be the key characteristics on the credit front, aggravated by some legal factors. But you will have to wait until either the next column or the one after that for the full story on that...

By keeping rates on hold at the last Monetary Policy Committee, or MPC, meeting two weeks ago, the Central Bank, or CBT, officially brought its year of easing to an end.

While the Bank is signaling its intention to hold the policy rate at the current rate of 6.50 percent for a long time, no one is buying. According to the CBT’s bimonthly survey, the policy rate is expected to be 8 percent in a year. A 1-1.50 rate hike is also penciled in most analyst reports, with rate hikes starting in the last quarter. The markets are even less kind, with cross currency swaps or benchmark bonds pricing in a tightening of 2-2.5 percent over the course of next year.

To be able to decide who is right, one first needs to understand how the CBT was able to cut rates much more than envisaged by anyone. For starters, arguing that the Bank just hopped on the global easing bandwagon would not explain why the CBT managed to decrease rates more than most other major Central Banks.

The major factor seems to have been the deep recession, which not only decreased inflationary pressures directly, but also reduced exchange rate pass-through to prices, which had been a major nuisance for the Bank in the past. The CBT was also definitely helped by unexpected (and unexplained) foreign currency inflows, which kept lira depreciation relatively contained after the Lehman collapse. With the economy starting to recover and the so-called UFOs, or unexplained financing objects having stabilized, it will be an entirely different ballgame next year.

Moreover, CBT’s key justification for holding rates, the large output gap, could be tested on two fronts in 2010. First, the latest data paint a mixed picture on the speed and strength of the Turkish recovery. While this is definitely not my base-case scenario, a pick-up quicker than as foreseen by the Central Bank would mean that inflationary pressures could be building up earlier than expected.

In fact, even with a slow recovery, the economy could be heating up unexpectedly if the country’s output gap turns out to be less than the Bank’s estimates. Some recent Fed and IMF papers argue that deep contractions lower potential output, and the sticky unemployment rate offers some early alarm bells that this could be the case for Turkey as well.

To make matters worse, as Central Banks around the world, especially Turkey’s peers, start to tighten, keeping rates on hold will be increasingly difficult for the CBT, as it could not only create pressure on the lira but also hurt the Bank’s credibility.

Speaking of credibility, the Bank is likely to face an uphill battle managing expectations next year. Rather than being supportive of monetary policy, fiscal policy, with the heavy redemption schedule early in the year, is likely to add to inflationary pressures.

While the government has not disclosed much, doing the math from the budget figures reveals administrative price and excise tax hikes are in the pipeline. This, coupled with base effects, means that inflation will be climbing in the first half of the year, which could also destabilize inflation expectations.

Last but definitely not the least, although most commentators ignored it, the lax medium-term inflation target, as outlined (but not fully justified) in the latest Monetary and Exchange Rate Policy report, could turn out to be a real obstacle to anchoring expectations.

The Central Bank will certainly try to postpone the rate hikes as long as possible. But I doubt that they will be able hold on until the last quarter, and may begin hiking rates as early as the second quarter.

Then, we’ll see who is right on the amount of the tightening, but I am putting my money on the markets this time around.

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