High interest rate to usher in low growth and higher unemployment
Following the Monetary Policy Board (PPK) decision to hike interest rates, the sustainability of the obstruction of the exchange rate with a high interest rate will also depend on domestic and international developments from now on. AA photoFaced with the shock of seeing the U.S. dollar hit 2.40 Turkish Liras, Turkey’s economic administrators were forced to take up the weapon of the interest rate that it was avoiding for a long time, especially upon the recommendations of Prime Minister Recep Tayyip Erdoğan.
With the decisions of the Monetary Policy Board that met on Jan. 28 at midnight, a sharp rise has been introduced in interest rates.
The one-week repo rate, which is considered to be the policy rate, has been increased 5.5 points to 10 percent. This is happening for the first time.
The surprising rise in the interest rate, deployed as a measure against the shock rise in the foreign exchange rate, resulted in foreign currency rates going down. While the dollar was approaching 2.40 Turkish Liras before the signals of the decision came, it went back down to 2.30 liras with the news of the Central Bank’s decision to hold an extraordinary meeting.
In the dollar’s course over the past 15 days, we have seen a scary fluctuation. The dollar, which was 2.13 liras on Jan. 13, went up to 2.26 on Jan. 23 and even though it experienced partial drops, its direction was always upward; and when it hit 2.40 liras on Jan. 27, the signal came from the Central Bank that it would raise interest rates sharply. After this signal, before the sharp rise decision was made, the dollar went back to 2.30 liras and with the midnight decision of the interest rate increases, went down to 2.16 on the morning of Jan. 29.
The sustainability of the obstruction of the exchange rate with a high interest rate will also depend on domestic and international developments from now on. If foreign investors with a portfolio totaling $127 billion in Turkey continue in their desire to exit in the face of the relaxing dollar, there are suggestions that this will push the dollar upward, and there might be a need for additional interest rate measures. Also, the FED has continued its money tightening and has given signals of interest rate increases. These may reduce the attractiveness of interest rates in Turkey, and this may lead to the exit of foreigners and again to the increase of foreign currency prices.
More importantly, the political tension experienced may not be adequate to eliminate the uncertainties both before and after the March 30 elections, and this, too, is an important factor that will affect the entry of foreigners and those who have entered before.
Who will be affected?
The transition from a high exchange rate to high interest rate climate will affect various segments differently. These interactions can be summed up as follows:
Downsizing: The most striking effect of high interest rate will be the negative one on economic growth. The increasing loan interests will hinder both investors and consumers. The growth which was targeted as 4 percent is expected to go down to 1-2 percent in the climate of a high interest rate. The cease of investments and the expensiveness of lira loans will cause an important recession in several sectors, primarily construction.
Credit usage, which has already shrunk with the risky course in credit cards, will become prohibitively more expensive with the new prices. The banking system will experience difficulties in selling credit and collecting repayments on loans. This will also result in a weakening of the finance system.
When the economic shrinkage causes a reduction in treasury income which predominantly consists of indirect taxes and consumer taxes, it may also cause an increase in budget deficits. Increased interest rates will also increase the treasury’s interest rate expenses.
Unemployment: In a high interest rate climate, several managements will downsize their capacities with the drop in domestic demand, meaning layoffs will begin. This will push official unemployment up to 13-14 percent; with the inclusion of unregistered unemployed, this rate will be over 20 percent. The downsizing will also cause a dangerous outcome of unemployment reaching 30 percent with the addition of young people expecting jobs.
Relative impoverishment: When the income entering households decreases with downsizing, a relative impoverishment will be experienced. Companies, in a depressed market, will refrain from increases in salaries, threatening their employees with the “either employment or severance” dilemma, even offering decreases in salaries. On the other hand, households, which have 330 billion liras worth of consumer loans, will face difficulties in paying credit card bills and installment repayments, and this will negatively affect the banking system.
With the transition to a high interest rate climate, the targets of the Medium Term Program (MTP) require a serious revision. As a matter of fact, the Central Bank made the first revision in inflation. The inflation target which was set at 5.3 percent in 2014 has been increased to 6.6 percent.
The growth target in MTP for 2014 was predicted at 4 percent. The drop in domestic demand and domestic consumption with the high interest rate will also reduce the acceleration of growth. It is highly probable that growth will stay at 1-2 percent. It will not be surprising for unemployment, which was forecast at 9.4 percent in the MTP, to reach double digits and see 12 percent. In the MTP, the average dollar exchange rate is covertly predicted at 1.98 liras. This prediction does not seem to be quite possible. It is expected that the dollar exchange rate, despite low growth and in connection with the low import demand, will not fall below 2.10 liras.
The high interest rate and low growth may cut into imports, and the resultant current account deficit, as well as the annual current account deficit, which is predicted at $55.5 billion in the MTP, may fall as the current income/national income rate will be lower than the 6.4 percent target, perhaps dropping to 5 percent.