Erdem Başçi: Recent economic and financial developments in Turkey
Speech by Mr Erdem Başçi, Governor of the Central Bank of the Republic of Turkey, at the
press conference for the presentation of the October 2011 Inflation Report, Ankara,
26 October 2011.
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Distinguished Guests,
Unlike former press conferences held to present inflation reports, today I would like to start
my presentation by explaining a five-point action plan entailing price stability, interest rate
policy, foreign exchange reserves policy, required reserves policy and financial stability.
We are living through a period marked by global developments that call for taking timely, and
if necessary, daily counter-cyclical measures against capital flows. Therefore, with the
Monetary Policy Committee's decision of October 20, 2011 we achieved the flexibility needed
to effectively implement the two-objective and three-instrument monetary policy on a daily
basis. After briefly mentioning the outlook for our primary objective of price stability, I will
summarize how and in which direction the three instruments will be employed from now on.
Lastly, I will also briefly talk about the positive impacts of decisions that have already been or
will be taken regarding financial stability.
Firstly, I will talk about price stability. We expect inflation to rise significantly in the
upcoming months due to recent excessive depreciation of the Turkish lira, the base effects
from unprocessed food prices and the recent adjustments in administered prices. I would like
to reiterate that we will not allow these developments to affect medium-term inflation
expectations and the medium-term inflation outlook adversely. Indeed, we have already
started the necessary monetary tightening to keep inflation under control and to ensure that
inflation realizations remain in line with the target set for 2012. Details on this issue can be
found in the Inflation Report that I will summarize shortly.
Secondly, I will talk about our interest rate policy. After the last Committee meeting, banks'
funding costs from the Central Bank were set within the interest rate corridor, in other words,
between 5.75 and 12.5 percent on average, or at a level that the Central Bank considers
appropriate. In cases where funding is effected at 12.5 percent, the Central Bank will meet
banks' demand with no upper limit and against eligible collateral. Tightening or easing to be
achieved via the funding channel will be implemented even on a daily basis depending on
the course of economic and financial developments. In the event that risks to price stability
are observed, the Central Bank will allow banks' overnight borrowing rates to hover around
12.5 percent for some time.
Thirdly, I will provide you with some information about our reserve requirement policy.
Depending on the outcome of the EU Leaders Summit and the foreign markets' perception of
this outcome, the Central Bank may introduce a limited reduction in the Turkish lira required
reserve ratios if deemed necessary. Moreover, we may also allow holding of up to 40 percent
of Turkish lira reserve requirements in foreign currency. Meanwhile, technical studies are
underway for enabling a facility that allows holding of 10 percent of Turkish reserve
requirements in gold. We believe that these three decisions will have positive impacts on our
banks, especially through the cost channel. Consequently, the Turkish lira liquidity to be
supplied to the market will significantly and permanently diminish the funding needs of our
banks; thus, favorably affecting the banking sector via the liquidity channel as well.
Now, I would like to talk about our reserve policy. Following the enabling of the facility that
allows holding precious metal deposit accounts and a part of FX reserve requirements in the
form of "standard gold", starting from October 28, 2011, we expect to see a rise in Central
Bank gold reserves from for the first time since 1991. Central Bank's gold reserves may
continue to increase once it holding of Turkish lira reserve requirements in the form of gold is
also allowed. The Central Bank purchased USD 26 billion-worth of foreign currency between
August 2009 and July 2011. These purchases were primarily aimed at prudently supplying
FX liquidity to our financial system, when needed, in order to support both price stability and
financial stability. Accordingly, should unhealthy price formations arise due to loss of depth in
the FX market, we can resume FX selling auctions or directly intervene in the FX market
without undermining the basic principles of the floating exchange rate regime. In addition,
depending on the global economic developments, we may resume intermediary activities in
our FX Deposit Market with the aim to enhance FX liquidity flow in the interbank FX market.
Lastly, I will briefly mention the issue of financial stability. We can summarize the core
objective of the policies we have been implementing since November 2010 as slowing down
the excessively rapid growth of the private sector's external liabilities and improving the
quality of these liabilities. Accordingly, the downward trend in the seasonally adjusted
monthon-month current account deficit, which started in July 2011, will continue in the final quarter
after a pause in September 2011. The steady rise in the shares of direct foreign investments
and long-term borrowing in the financing of the current account deficit continues. We believe
that further slowing down of the current pace of growth, especially in consumer loans, in the
rest of the year would contribute to the sustainability of the rebalancing of domestic and
external demand. Thus, the rise in the private sector's propensity to save in Turkey will
ensure a more rapid and sound correction in the current account deficit. In the upcoming
period, effective liquidity management through the interest rate corridor will become an
important policy instrument that will also contribute to financial stability.
Distinguished Members of the Press,
Now, in order to provide more detailed information on the price stability pillar of the
framework that I have just mentioned, I would like to share with you the main messages of
the October Inflation Report.
The Report typically summarizes our evaluations on macroeconomic developments and
presents our revised medium-term inflation forecasts, along with our monetary policy stance.
In addition to the main sections of the Report, we have provided nine boxes that analyze
various topics. These boxes, like usual, evaluate the findings of studies on some interesting
current topics. For instance, we have a box on the crisis and debt sustainability in the Euro
area. Also, we have boxes that elaborate two popular topics that have been occupying the
top of the agenda for some time. In one of these boxes, the method of taxing tobacco
products and its impact on consumer prices is analyzed, while in the second box, we share
our current forecasts on exchange rates and import price pass-through. You can see titles of
other boxes on the other slide. All of them contain informative analyses on the Turkish
economy. These boxes will be published shortly on our website; I recommend you to read
them.
Distinguished Members of the Press,
Global economic developments have been influential on our policies for quite a long time.
Therefore, in the first part of my speech, I would like to continue with a brief summary of
these developments.
In the third quarter of 2011, mounting concerns regarding sovereign debt sustainability
across the euro area, coupled with the slower-than-expected recovery in U.S. real estate and
labor markets intensified the downside risks regarding global economic activity. Accordingly,
global economic activity forecasts were revised downwards and expectations for a further
delay in the normalization of monetary policy in advanced economies grew stronger.
Mounting uncertainties regarding the global economy and the deterioration in risk appetite
led to capital outflows from emerging economies. This outlook not only fed into short-term
inflationary pressures in emerging economies, but also highlighted concerns over growth and
financial stability.
1. Monetary policy developments and monetary conditions
The policies that we, as the Central Bank of the Republic of Turkey (CBRT), have been
implementing since end-2010, aimed at gradually rebalancing the economy towards a robust
growth composition without hampering the medium-term inflation outlook. Accordingly, we
pursued policies to prevent excessive deviation of exchange rates from economic
fundamentals in either direction, while also taking the necessary measures with the support
of other institutions to ensure reasonable levels in loan growth rates (Chart 2 and 3).
As a consequence of measures taken by the Central Bank and the Banking Regulation and
Supervision Agency (BRSA), loan rates continued to rise in the third quarter (Charts 4
and 5). A marked slowdown is observed in credit growth owing to the lagged effects of
measures taken and a deceleration in economic activity. Despite the role of seasonal factors,
this slowdown is more apparent compared to that of recent years (Chart 3). Accordingly, the
exchange-rate-adjusted annual credit growth rate is expected to converge at around
25 percent by year-end, as envisaged.
In the baseline scenario presented in the July Inflation Report, global economic activity was
assumed to continue to improve gradually; however, it was also highlighted that downside
risks on the global economy were growing stronger. Indeed, right after the publication of the
Report, risk perceptions deteriorated rapidly and debt problems in the euro area further
intensified changing the baseline scenario. In response, we introduced a comprehensive
package of measures to contain the potential adverse effects of these developments on
financial stability and economic activity. The objective of these measures was to supply
liquidity to markets in a timely, controlled and effective manner in the event of financial
turmoil that may be driven by developments in the global economy. Moreover, we opted for a
modest cut in the policy rate in order to contain the risk of recession in domestic economic
activity that may be posed by escalating global economic problems. Moreover, Turkish lira
required reserve ratios were adjusted in order to extend the maturities of liabilities of the
banking system (Chart 6). The mounting uncertainties facing the global economy since the
July Inflation Report and accelerating capital outflows from emerging economies called for a
series of measures intended to contain fluctuations in the foreign exchange market.
Distinguished Guests,
Ongoing deterioration in the global risk appetite, which started in August, has led to
excessive depreciation of the Turkish lira. The accumulated depreciation of 30 percent since
November 2010 started to pose risks on the inflation outlook. Moreover, in October,
adjustments made to administered prices, which were far beyond the assumptions of the July
Inflation Report, necessitated a sizeable upward revision of short-term inflation forecasts. At
this point, I would like to underline that we would not allow the medium-term inflation
expectations and outlook to be affected by these developments, and we will take all
necessary policy measures. The policy measures that I mentioned earlier in my speech and
the Committee decision of October stipulating a significant increase in the overnight lending
rate should be viewed from this perspective (Chart 6).
2. Inflation and monetary policy outlook
Distinguished Members of the Press,
I would now like to discuss the macroeconomic outlook and the assumptions underlying our
forecasts. First of all, I will summarize the recent inflation developments and then I will
compare the short-term forecasts we announced in July with data realizations in the third
quarter. In the third quarter, prices of core goods posted a more-than-envisaged increase
amid excessive depreciation of the Turkish lira. The annual rate of change in food prices
declined significantly due to the base effect in unprocessed food prices. As seen on the slide,
inflation followed a flat course during the third quarter as these two effects largely offset each
other (Chart 7). However, exchange rate developments ended up being more dominant
which led inflation to exceed the forecast range presented in the July Inflation Report.
In the third quarter, exchange rate developments led to an increase in the underlying trend of
core inflation indicators as well (Chart 8). This was mainly triggered by the increase in prices
of core goods, while the underlying trend of services inflation remained relatively modest
(Chart 9).
Distinguished Guests,
Gross Domestic Product (GDP) data indicated more robust economic activity in the second
quarter of 2011 compared to the outlook presented in the July Inflation Report. Therefore, the
output gap estimates of this period were revised upwards. Private sector consumption and
investment expenditures became the main drivers of growth in this period. While exports
followed a weak course amid developments in the global economy, imports recorded a
significant decline following the slowdown in domestic demand due to the policy measures
adopted. Thus, the net external demand made a positive contribution to growth on a
quarterly basis for the first time after a long stretch. In other words, the composition of growth
started to change in the desired direction (Chart 10).
Owing to the lagged effects of the contractionary reserve requirement and liquidity policies,
domestic demand continued to lose pace in the third quarter. Also, due to measures taken by
the Banking Regulation and Supervision Agency (BRSA) and the tight fiscal policy stance,
domestic demand growth was brought to a sustainable level in the third quarter. In this
period, credit, production and sales data, as well as confidence indices, indicated ongoing
loss of momentum in private consumption demand. In this context, the outlook for the third
quarter was based on an ongoing slowdown in domestic demand (Chart 11).
Driven mainly by advanced economies, global growth forecasts were subject to substantial
downward revisions in the third quarter. In this respect, projections for Turkey's
exportweighted global growth index point to a weaker medium-term outlook compared to the
previous period (Chart 12). Therefore, forecasts were based on an outlook of weaker
external demand compared to the previous period.
Consequently, the output gap was revised upwards for the short-term and downwards for the
medium term. Moreover, assumptions on oil and other commodity prices were revised
slightly downwards (Chart 13). You can see the effect of these revisions on 2011 and 2012
year-end inflation forecasts (Table 1).
Esteemed Guests,
In the July Inflation Report, the price increases in tobacco products were assumed to be
consistent with the inflation target, adding approximately 0.3 percentage points to inflation.
However, considering recent developments, the estimated contribution of price increases of
tobacco products to inflation is revised upwards to 0.9 percentage points. This has led to an
increase in short term inflation forecasts by 0.6 points (Table 1).
The assumptions about fiscal policy used for medium-term forecasts were based on the
outlook presented in the Medium Term Program (MTP). Therefore, the baseline scenario
envisages that the ratio of primary expenditures to GDP would gradually be reduced from
2012, the public debt-to-GDP ratio would continue to fall, and the risk premium would remain
broadly unchanged. Moreover, tax adjustments and administered prices are assumed to be
consistent with inflation targets and automatic pricing mechanisms.
Distinguished Members of the Press,
As I have already stated, since the publication of the July Inflation Report, emerging
economies have faced rapid capital outflows due to the deteriorating risk appetite. In this
respect, excessive depreciation in the Turkish lira has become more evident. This
development, coupled with the increase in prices of administered goods, has raised the risk
of deterioration in pricing behavior. We responded to these developments strongly by
increasing our overnight lending rate markedly in our October meeting (Chart 6). We expect
monetary tightening to contain inflationary pressures in the period ahead. However, inflation
is forecasted to increase significantly in the short term with the contribution from low base
effects in unprocessed food prices.
Assuming that the annual rate of credit growth decelerates gradually, and monetary
conditions are tightened significantly in the final quarter in line with policy measures taken in
October, inflation is expected to be, with 70 percent probability, between 7.8 and 8.8 percent
with a mid-point of 8.3 percent at the end of 2011, and between 3.7 and 6.7 percent with a
mid-point of 5.2 percent at the end of 2012. Inflation is expected to stabilize around 5 percent
in the medium term (Chart 14).
I would like to reiterate that any new data or information regarding the inflation outlook might
lead to a change in the monetary policy stance. Therefore, assumptions regarding the
monetary policy outlook underlying the inflation forecast should not be perceived as a
commitment on behalf of the CBRT.
In sum, short-term inflation forecasts were revised on the upside mainly due to exchange
rate developments and hikes in administered prices. I would like to underscore that these
factors reflect a movement in relative prices rather than a permanent increase in inflation, as
the monetary tightening envisaged in the last quarter in the context of the CBRT's recent
strong policy reaction will prevent second round effects.
Distinguished Guests,
I would like to highlight once more that the recent tightening in the CBRT's policy stance
aims mainly to prevent deterioration in inflation expectations triggered by inflationary
pressures from the exchange rate. At this point, it is important to ask a counterfactual
question: what would the path of inflation have been had the CBRT not reacted? To provide
more guidance on this matter, I would like to draw your attention to the chart (Chart 15). The
chart depicts accumulated price increases resulting from exchange rates and administered
price developments, in the case of no reaction by the CBRT. Accordingly, we estimate that
the contribution of these developments to inflation would have reached 6 percentage points,
had the CBRT not taken any policy measures.
In this scenario, consumer inflation reaches double digits at 10.1 percent, owing mainly to the
excessive depreciation of the Turkish lira, also coupled with the effect of the deterioration in
inflation expectations (Table 2). Therefore, given the backward looking pricing-behavior in the
services sector, inflation would hover at elevated levels for an extended period of time. This
would lead to a deterioration in inflation expectations, and risk the hard-earned recent
achievements on the path to price stability. In such a case, bringing inflation back to
reasonable levels would be more costly. In order to prevent such adverse developments, the
CBRT intervened actively in the foreign exchange market; and in line with its primary objective
of price stability, responded boldly by increasing overnight lending rates significantly. Besides,
we have explicitly stated that the CBRT, in line with the strategy announced today, will not
allow exchange rates to deviate from economic fundamentals, nor will it allow a deterioration
in price stability and financial stability. I would like to reiterate that various measures will
continue to be taken in the forthcoming period, in order to ensure price stability.
3. Risks and monetary policy
Distinguished Members of the Press,
In the last part of my speech, I would like to mention risks regarding the inflation outlook and
how the monetary policy will be shaped should these risks materialize.
The fact that inflation will hover above the target in the short term poses risk to inflation
expectations and price setting behavior. Accordingly, as of October, the CBRT has adopted a
policy stance aimed at eliminating these risks. These risks will be closely monitored and the
necessary measures will be taken to avoid deterioration in the medium-term inflation outlook.
Medium term projections assume that the global outlook will remain weak for a long period,
but the situation will not worsen further. Nevertheless, uncertainties regarding the global
economy continue to be of significant concern. Especially, mounting problems regarding the
sovereign debt of euro area economies continue to pose downside risks on the global
economy. Concerns regarding the debt sustainability of euro area economies have further
increased since the publication of the July Inflation Report, exacerbated by the concerns of a
possible contagion to the region's banking sector. In this context, the CBRT will continue to
monitor global economic developments closely and will take the required measures promptly
to maintain stability in domestic financial markets.
While formulating the monetary policy, we will continue to monitor fiscal policy developments
closely as well. In this respect, our forecasts presented in the baseline scenario take the
Medium Term Program as given and thus assume that fiscal discipline will be maintained. A
revision in the monetary policy stance may be considered, should the fiscal stance deviate
significantly from this framework and consequently have an adverse effect on the
mediumterm inflation outlook.
In the period ahead, monetary policy will continue to focus on price stability while preserving
financial stability as a supporting objective. To this end, the impact of the macroprudential
measures taken by the CBRT and other institutions on the inflation outlook will be carefully
assessed. Strengthening the commitment to fiscal discipline and the structural reform
agenda in the medium term would support the relative improvement of Turkey's sovereign
risk and thus, facilitate macroeconomic and price stability. Sustaining the fiscal discipline will
also provide more flexibility for monetary policy and support social prosperity by keeping
long-term interest rates permanently at low levels. In this respect, I would like to conclude my
remarks by underlining that timely implementation of the structural reforms envisaged by the
new Medium Term Program remains to be of the utmost importance.
Thank you for your participation.