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US Monetary Dynamics and Turkey: A Case of Interdependence

February 20, 2014

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The recent monetary actions in US have implications for emerging markets. Tapering and the reduction of asset purchase program in the US create incentives for portfolio and investment flows to be reallocated to higher yielding risk-adjusted assets across the globe. Turkey is an interesting case of interdependence; it demonstrates how monetary dynamics in US and economic uncertainties in a foreign country impact investors portfolio flows and the domestic currency. For starters, that the economic outlook for the Turkish economy is gloomy due to the following reasons:

  • Leading indicators suggest that the economic activity decelerated in the second half of 2013;
  • Private consumption that accounts for 70 percent of GDP is slowing;
  • Credit growth has weakened in the last quarter of 2013;
  • Improvements in business confidence and economic outlook are diminishing;
  • Imports continue to outpace exports contributing to the widening of the cumulative trade deficit ($97 billion, up 14 percent year-over-year);
  • Current account deficit is projected at 7.1 percent of GDP the highest among major emerging markets; and
  • The central bank of Turkey has missed inflation targets of 6.8 percent in 2013 and 5.3 percent in 2014. The current updates point to inflation of 7.5 percent in 2013 and projection 6.6 percent in 2014. The new figures exercise downward pressure on currency values and accelerate portfolio outflows to other higher risk-adjusted opportunities.

In such an environment characterized by lower-than-expected growth and lack of structural reforms, Turkey appears not be ready to absorb an external global shock from changes in the monetary policy in the US or from other exogenous events. A gradually reduction of the asset repurchase program of the Federal Reserve in US will motivate portfolio investments to move away from Turkey towards higher-yielding investments in US. Such portfolio outflows create downward pressures on the Turkish lira and have forced the Central Bank of Turkey to adjust interest rates in an aggressive way to contain substantial currency devaluation. As global flows and portfolio investments continue the cycle of readjustment due to Fed’s monetary normality, Turkey like many emerging markets will be scrutinized on its ability to grow its economy and contain investors’ risks; these risks are associated with both country/geopolitical uncertainties and risks imported to Turkey from expected global monetary changes. Policy responses in Turkey as a result of these risks have overshoot expectations and have contained portfolio and investment flows in the near term. However, in the medium term, it is not clear if the global monetary dynamics will make capital and portfolio flows to be sustainable in Turkey. This remains a big question in Turkey during a year where elections may shift the political winds in a different direction. Given increased political risks, the Fed’s decisions that lead to normalized monetary conditions in US may have an impact on the Turkish currency and the economy.

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