With Europe’s worrisome sovereign debt crisis, America’s troubling quantitative easing experiments and China’s challenge to cool its surging economy without freezing it solid, there are plenty of big economic stories unfolding right now. This means smaller but no less interesting news items are sometimes overlooked.
One such blip was the decision by the Central Bank of Turkey, the CBRT, to cut its interest rates last December. Looking at Turkey’s overall economic situation, it’s difficult to find strong arguments for or against this move. The Turkish economy is performing quite well, with growth down a bit from earlier unsustainably high levels, and inflation, while still above 7%, has not reaccelerated.
Such a placid environment might normally induce inertia in a central bank, but the rate-cutting decision itself was not very remarkable, hardly worth more than a passing nod of acknowledgment from observers. However, the reason given for it, as served up in the CBRT’S communiqué, really was rather astonishing: the rate cut was made to prevent the economy from overheating. No, you didn’t read that wrong: this strange statement was then reiterated by Erdem Basci, a deputy governor of the bank.
First, a short explanation: cutting interest rates to cool an economy down not only contradicts basic macroeconomic theory, more tellingly, it even violates common sense: if interests are trimmed, doesn’t this induce firms and households to borrow, and spend, more? And wouldn’t this in turn increase demand and therefore boost growth? Or did we miss something?
Yes, actually, we did. Like Brazil and several Southeast Asian emerging markets, Turkey has become a favored destination for vast inflows of international capital. Obviously, with interest rates are near zero in the US and the core of Europe, investors are seeking returns elsewhere, moving assets into regions that promise high yields. And when a country reduces yields, by cutting interest rates, this can have a dampening effect similar to introducing capital controls: lower rates should reduce the capital inflows and thus cool the economy down.
This is the reasoning but does it apply here? There are several caveats, in our view. The rate cut mostly just affects money-market instruments and the like. Yes, international investors who use these sorts of vehicles to invest in Turkey might now face less attractive opportunities. But those who are investing directly into the country, by buying bonds, equities or real estate, will not at all be deterred by a rate cut from the central bank.
Moreover, while the rate cut may reduce international capital inflows into Turkey, it should also significantly boost domestic credit activity and consumer spending. It could even be said that this measure attempts to shift the engine of growth from international investments towards domestic consumption, which, in the longer run, may prove a far less sustainable growth model.
Finally, by cutting interest rates, the CBRT has substantially weakened the Turkish lira, which increases the price of imports. A large part of the Turkish current account deficit comes from energy imports, and with the weaker lira these imports just got more expensive. Hence, at least through this channel, the rate cut exacerbates the very problem it was meant to solve, since higher energy prices will drive up the current account deficit. To counter these inflationary effects, we note, the TCMB has raised reserve requirements for banks, constraining their ability to make loans.
If you are not living in Turkey, you might find this an interesting little story but might also ask why you should about the machinations of the Central Bank of Turkey. In fact, while Turkey might be the only country conducting a rather convoluted monetary policy at the moment, several others are thinking about similarly contradictory measures. In this respect, Turkey’s rate cut can be seen as just another skirmish at the fringes of a simmering currency war.
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