Monday, January 3, 2011

Weekly Hurriyet Column: Lock, stock and three smoking barrels

Below is the unedited version of my column for this week. You can read the final version at the Daily News website, but since I have been editing my columns myself on the Daily News media webeditor since March, you won't see much of a difference between the two. As for the title, it  is  a reference not only to the expression, lock, stock & barrel, but also to Guy Ritchie's movie: The idea is that if he has two smoking barrels, I just have at least one more:) Joking aside, I wanted to highlight the three main risky ares of the Turkish economy... 
As for an addendum, I would like to sketch how I came with the forecasts: My main forecasts were growth as derived from the National Income Accounts, or NIA; everything else depended on it or just fed into it: Within growth, I looked at domestic and external demand separately. Withing domestic demand, I weeded out inventory buildup and treated government spending exogenously: With the latter, while I was rather "generous" for the first half of the year, I did allow some pullback after the elections. I also projected consumption and investment separately, while they did some common explanatory variables. For consumption, in line with the fad nowadays, credit growth turned out to be a determining factor, whereas the rest were just "reasonable assumptions" on consumer confidence and the like. For credit growth, I adopted two approaches: For one thing, I took the credit growth as exogenous (nominal 20-25 percent growth) and determined capital flows accordingly. Then, I also, by making simple assumptions about capital flows to emerging markets and Turkey's share of the cake (using EPFR and IIF figures), I took capital flows as exogenous and got a credit growth rate consistent with that.
Everything else either fed into or was derived these main numbers: For example, the fiscal and debt figures, which I did not mention in the column, are all "made" consistent with government spending, using simple linear relationships. Similarly, the Balance of Payments are in line with capital flows , credit growth and external demand of the NIA. But it is important to note that I did not rigorosuly forecast all the variables. For example, it is impossible to formally project FDI, so I just penciled in a logical number ($10 billion). Base money, on the other hand, depended on the capital flows as well as the Central Bank's actions, with the former semi-exogenous and the latter exogenous in my framework. 
Which brings me to the tricky part of these projections: Monetary policy. It is clear that the traditional Taylor Rule does not do a good job in forecasting even the direction of monetary policy any more, so I  took monetary policy as exogenous into my framework, assuming some more policy rate cuts  & reserve hikes in the first quarter, more of hold-and-wait in the second quarter, when a new Governor will be appointed, and some forced policy reversal in the second half. Luckily, the reversals do not play a  big role in my inflation forecasts due to the lagging nature of monetary policy on inflation. I used standard inflation forecasting equations, with the output gap and credit growth playing the most role. 
Note that although I did pour quite a bit of effort into it, this is not the only way I would have done it, if I had more time and resources. For example, while I do not appreciate that most policymakers nowadays treat it as God's word, a DSGE model would have solved my endogenity issues. But those take time to build, and even more time to maintain, so there is no way I am getting into such deep shit unless I am paid to do so. Therefore, I had to stick with my piecewise solution, making sure that there are no inconsistencies in the framework... 
Anyway on to the column:  
“Stock” is the name of the game in my first column of the year: I would like to take stock by going over my 2010 forecasts of the Turkish economy as well as offer my lock, stock and barrel projections for 2011.

My 2010 Report Card…

One factor singlehandedly messed up most of my beginning-year projections: I did not expect capital flows to be so strong. As a result, growth came in much larger than I expected, which also affected my other projections: The budget deficit came in lower, mainly on the back of stronger than expected tax revenues. Similarly, the current account deficit was higher, another artifact of the strong growth.

On the positive side, I once again hit bull’s eye with inflation. And I was once again right on target with my policy predictions. I did not mind being in the minority when I claimed the IMF Standby Arrangement and the fiscal rule would not go through. And unsurprisingly they didn't.

Then, there is monetary policy, which warrants a separate paragraph: For the first three quarters, the Central Bank of Turkey, or CBT, was quite predictable, except for once, when I got under the impression that the Bank would start hiking during the summer, and on live TV at that, prompting the host to wonder what I had been smoking.

Nothing, really! It was just that I was able to see the strong growth in the economy as early as in April, thanks to my work at Konda, and was assuming the Bank would address that early on. Needless to say, the other forecasts I revised in April-May were rather accurate.

And the 2011 outlook…

For 2011, I see growth slowing to 4.5-5 percent. The economy is already near its potential, and the nature of the growth is unsustainable, so if anything, there are even downward risks to this forecast. Very strong capital flows, bolstered by a ratings upgrade early on, on the other hand, could lead to stronger growth.

The current account figure consistent with this growth figure is around $65 billion, assuming oil prices average out to about $85-90 per barrel. Then, along with a debt service and short-term trade credits of around $35 billion each, Turkey would have an external financing requirement of around $135 billion. The question is whether this can be financed painlessly.

Once bitten twice shy, so I am assuming capital flows will continue to be strong this year. A ratings upgrade to investment grade by Fitch, which would soon be followed by the other agencies, after the ruling AKP’s election victory in June, would boost this scenario further. But external financing is nevertheless one smoking barrel of the Turkish economy this year.

The second barrel is pork barrel spending: Contrary to common belief, fiscal policy has been pro-cyclical this year once adjusted for the strong growth (i.e. the business cycle), although the government has not really opened up the coffers so far. That is sure to change during the first half of the year. While the government’s deficit target seems achievable, too much profligacy, combined with slowing growth, could lead to nasty surprises.                

The final barrel is inflation and monetary policy: With the output gap closed down and price-setting behavior still sticky, inflation is more likely to end the year in the 6.5-7 percent range rather than fall to 5.4 percent, as the CBT envisages. And that is with the Bank forced to reverse gear later in the year, after a couple of reductions in policy rates early on, once inflation begins to move out of control and its unconventional policy seems not to be working.

If global or domestic developments do not cause one of these three barrels to explode, the Turkish economy could as well have a good year.

Emre Deliveli is a freelance consultant and columnist for Hürriyet Daily News & Economic Review and Forbes as well as a contributor to Roubini Global Economics. Read his economics blog at

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