On the week, benchmark Treasury yields fell 3-8bp, with almost all of the net upside posted Friday in response to the run of bad news out of Europe. The 2-year yield fell 3bp to 0.17%, 3-year 2bp to 0.29%, 5-year 6bp to 0.81%, 7-year 6bp to 1.33%, 10-year 8bp to 1.92%, and 30-year 6bp to 3.25%, all at or very close to record-low closes. This pattern of relative performance was a bit of a shift from the recent norm of the 2-year barely budging and the 30-year the highest beta part of the market in both directions, with the slight steepening in 10s-30s and new low for the 2-year yield reflecting elevated expectations for near-term Fed action. Confirming widespread market expectations, the Wall Street Journal's Jon Hilsenrath reported Thursday (see his article, Fed Prepares to Act) that the Fed is moving towards implementing an ‘Operation Torque' duration extension of its securities portfolio at the September 20-21 meeting and is also giving some consideration to cutting the interest rate on excess reserves and perhaps providing explicit unemployment and inflation rates needed before any policy tightening. A portfolio duration extension seems almost assured to be announced on September 21 (if not earlier if market conditions were to prompt concerted global central bank action) and concerns about worsening downside risks to the global growth outlook had investors seeing higher odds of a cut in the IOER as well. With the plunge in the euro versus the dollar Friday heavily pressuring commodity prices, TIPS performed relatively poorly Friday while nominals were rallying, leaving their yields for the week mixed. The 5-year TIPS yield rose 1bp to -0.90%, 10-year yield fell 2bp to -0.07%, and 30-year yield rose 5bp to 0.96%.
As the Fed moves towards new easing measures, fiscal policy is also becoming more of a market focus after President Obama's speech proposing $447 billion in stimulus, though we are skeptical of the plan's prospects in Congress. Many of the president's initiatives, especially on the spending side, are likely dead on arrival in the House of Representatives. But there were three important aspects of the president's speech that will likely be the key areas of debate in coming months and that could have a material impact on the 2012 growth outlook, depending on how they are resolved - extending and expanding the payroll tax cut, extending funding for extended unemployment benefits, and implementing a plan to try to accelerate home refinancing through restructuring of the, to this point, largely failed Home Affordability Refinance Program (HARP).
The Social Security payroll tax is 12.4% of taxable wages up to $106,800 this year (indexed to inflation), split between 6.2% paid by employers and 6.2% by employees. The payroll tax cut in place this year lowered the employee side by 2pp to 4.2% at an estimated cost of $120 billion for the year. The president proposes to cut the employee side further to 3.1% for next year at an estimated cost of $175 billion (a third bigger incrementally from what is currently in place) and also to cut the employer side in half to 3.1% on the first $5 million in payroll and to zero for net new increases in payrolls (up to a limit of $50 million) next year at an estimated cost of $65 billion. The employee side cut is ultimately an attempt to stimulate consumption; the employer side would more directly try to spur hiring through lowering labor costs. The estimated combined cost of $240 billion would be double the $120 billion payroll tax cut in place this year. Our baseline forecasts assume expiration of the current tax cut on schedule at year-end, for a fiscal tightening of about 0.8% of GDP. A full approval of this part of the president's plan would instead be net new stimulus of 0.8% of GDP. In addition to the fight over the payroll tax cut, the prospects for extending federal extended unemployment benefits for another year is the other key near-term fiscal policy uncertainty. Extended benefits funding expires at year-end, after an estimated cost this year of about $55 billion. The president proposes extending this another year at an estimated cost of $49 billion (he has also proposed some additional spending on unemployment programs that bring the total cost of the "Pathways Back to Work for Americans Looking for Jobs" section of the speech to $62 billion, but these new initiatives probably have a smaller chance of passage).
House Republican leaders have generally been cold towards the idea of more temporary stimulus measures, including payroll tax cut extension, though they expressed initial openness to considering the president's proposals, with House Speaker Boehner saying they "merit consideration". But there are high political hurdles to getting much done, as debate on these proposals immediately becomes entangled in what was already likely to be a contentious battle over the super committee's - which already had one of its 12 members threatening to abandon the talks after its first meeting on Thursday - attempt to find a majority plan for $1.2-1.5 trillion in 10-year deficit cuts by Thanksgiving. Any new stimulus actually approved will need to be offset by additional reductions on top of that $1.2-1.5 trillion baseline, which itself will be hard to reach and could be the source of another ugly debt debate in Congress between Thanksgiving and Christmas along the same lines as what happened in July. The president said that in "coming days" he would come forward with a proposal for how to pay for his proposals in the context of the super committee, but it seems unlikely that his proposed offsets will be acceptable to Republicans. Indeed, Representative Jeb Hensarling, the Republican co-chair of the super committee, released a statement saying that the president's proposals "would make the already arduous challenge of finding bipartisan agreement on deficit reduction nearly impossible". So, our base case is that the payroll tax cut and extended unemployment benefits expire on schedule at year-end and that there is no material new stimulus aside from potentially some support from a restructured HARP that accelerates mortgage refinancing. Certainly, however, there is some meaningful chance that Congress and the president could agree on proposals of some significance that would provide a boost to the baseline outlook for growth next year, and this remains a key near-term uncertainty in the US growth outlook. There is an estimated $175 billion, or 1.2% of GDP, between the payroll tax cut and extended unemployment benefits scheduled to expire at year-end, and the president proposes extending those and doubling the payroll tax cut at an estimated cost of $289 billion, or 1.9% of GDP, not a lot of net new stimulus but a substantial possible positive swing relative to our baseline assumption of expiration.
While this debate in Congress is ongoing, streamlined mortgage refinancing can be pursued by the Administration under its regulatory authority without requiring new Congressional action, but initial indications suggest that the White House is taking a relatively conservative approach, working to try to fix the problems that have made the HARP so much less effective than initially estimated rather than attempting to implement a broader new program. Ultimately, how successful these efforts are in letting more homeowners with low or negative home equity refinance into current record-low mortgage rates will probably depend on how robust an effort the Administration is willing to make to change the approach of the Federal Housing Finance Agency in guiding the GSE's tightening mortgage lending standards and how much of a reversal of sorts it is willing to make on mortgage reps and warranties to provide banks originating the new mortgages protection against future putbacks. Fed Governor Duke in a recent speech explained how the approaches of the FHFA, GSEs, banks and mortgage insurers have resulted in HARP so far having such a disappointing impact (see her September 1 speech, The Housing Market Going Forward: Lessons Learned from the Recent Crisis). She identified four major problems - high credit risk fees ("loan-level pricing adjustments") charged by the GSEs under FHFA direction for low equity borrowers, limited participation by mortgage lenders because of fears of putback risks on the original and refinanced loans, junior lienholders refusing to remain subordinate to a refinanced primary mortgage, and mortgage insurers declining to reunderwrite the refinanced loans. But "in each case, the parties to the transaction are applying standard risk-management tools that would normally apply to low- or no-equity loans - but they are applying them to risk they already own" and they are failing to recognize that "if the first mortgage becomes more affordable, the existing risk exposure of all credit risk holders actually decreases". Intervention by Treasury to convince FHFA to change its current approach on guarantee fees and reps and warranties could make this program significantly more effective, helping to lower interest costs for homeowners and reducing incentives for strategic defaults. Higher-coupon mortgages lagged the Treasury market gains a decent amount on the week as investors priced in somewhat faster expected prepays, with Fannie 5s lagging by about 15 ticks on the week, 5.5s 7 ticks, 6s 12 ticks, and 6.5s 8 ticks. This followed underperformance of about two-thirds of a point by these issues two weeks ago after the New York Times first reported that a streamlined refi program was being considered, but then a reversal of more than half of this underperformance in the week before Labor Day when these expectations were initially scaled back. So, on net over the past three weeks investors have moved to price in a modest impact from the efforts to unblock refinancings of high rate mortgages. Meanwhile, lower-coupon mortgages rallied about in line with Treasuries over the past week, leaving current-coupon MBS yields near the prior record low of 3.15% at week-end as Treasury yields were also moving to new lows. Even before the additional rally Friday, Freddie Mac's weekly survey showed that the prior gains in the MBS market had lowered the national average 30-year mortgage rate to a record low 4.12% in the latest week.
The economic calendar over the past week was unusually light, but a very strong international trade report and a jump in wholesale inventories in July pointed to upside to 3Q GDP growth. The trade deficit narrowed to $44.8 billion in July, near the low of the year, from $51.6 billion in June, a nearly three-year high, with exports surging 3.6% and imports dipping 0.2%. The export gain more than reversed a 2.5% drop over the prior two months and was led by big gains in capital goods, industrial materials and autos. Meanwhile, the import softness reflected a sharp pullback in petroleum products on lower prices and volumes that was largely offset by a surge in autos as production recovered from spring supply-chain disruptions. Other major import categories were a bit weaker overall, in line with sluggish domestic demand growth. We now see net exports adding 0.9pp to 3Q GDP growth instead of subtracting 0.3pp, with real exports expected to be up 10% and real imports 2%. Details on capital goods exports and imports were a bit of a negative offset, and we now assume lower inventory figures in response to the more sluggish imports outlook (though this was not seen in a big gain in wholesale inventories in July). Taken together, we boosted our 3Q GDP estimate to +3.1% from +2.6% in response to this report. It's important to keep in mind with this forecast, however, that it is being driven by upside in data for July and June, with better-than-expected results also seen in the July durable goods, IP, and personal income and spending reports. Arithmetically, the level of activity in the first month of a quarter and the last month of the prior quarter are the most important determinant of the quarterly growth rate (the ‘ramp' we often mention), and clearly, focus now has turned to what extent the economy has decelerated since the August shock to confidence and continued weakness in markets into September much more so than the solid start 3Q got off to coming out of June and July.
The US economic calendar is much busier in the coming week, but developments in Europe seem likely to continue to be the biggest concern for global markets. Aside from any news out of Europe, Treasury market focus in the first part of the week will be on supply to a significant extent, with a $21 billion reopening of the 10-year Tuesday and $13 billion reopening of the 30-year Wednesday after a less challenging $32 billion 3-year auction Monday (the normal Tuesday to Thursday schedule having been moved up a day to allow settlement on Thursday, the 15th). Key data releases due out include the Treasury budget Tuesday, retail sales and PPI Wednesday, and CPI and IP Thursday. The University of Michigan consumer confidence survey Friday, and Philly Fed manufacturing survey Thursday will also likely receive heightened attention after extremely weak results last month:
* We estimate that the federal government's budget deficit widened to $134 billion in August from $91 billion a year earlier, with revenues rising 2.7%Y and spending up 18.7%. Withheld income taxes appear to have shown continued good growth in August, but this was partly offset by the impact of the payroll tax cut and accelerated corporate tax depreciation allowances. Most of the spending upside reflects a calendar shift that moved a significant amount of August payments into July in 2010. On an underlying basis, a flattening out in defense and lower spending in cyclical areas like unemployment insurance and Medicaid continues to restrain overall outlays. The budget deficit for all of F2011 (ending in September) appears likely to be very close to last year's $1.294 trillion deficit, leading to a slight narrowing as a percentage of GDP (8.7% versus 9.0%).
* We forecast a 0.1% gain in overall retail sales in August and a 0.5% rise ex autos. The auto dealer category is expected to register a pullback, but chain store results were better than expected, and anecdotal reports suggest that hurricane preparation near the end of the month spurred activity at hardware outlets, grocery stores, drug stores and discount department stores. Gains in these categories should help to offset softness in apparel and home electronics. The key retail control category which factors directly into the calculation of consumer spending is expected to match the 0.3% rise seen in July.
* We expect the producer price index to rise 0.1% in August overall and excluding food and energy. Quotes for wholesale gasoline were little changed in August (after seasonal adjustment), while food prices appear to have edged up only modestly. Meanwhile, the core is expected to post only a fractional rise, reflecting some moderation in the volatile motor vehicle category and a softening in commodity prices.
* We forecast a 0.3% rise in the overall consumer price index in August and a 0.2% gain in the core. Although prices at the gas pump started to move lower during August, the decline for the month as a whole was less than anticipated by the seasonal adjustment factor. So, the energy category is expected to post a modest rise in August. Meanwhile, food prices are expected to post a slightly more modest gain than seen in recent months. The core should be in line with the recent trend, as the shelter category continues to show an underlying acceleration due to tightening in rental market conditions (although it may be restrained a bit in August by a temporary dip in hotel rates). On a year-on-year basis, the core should tick up to +1.9%.
* We look for a 0.2% gain in August IP. Motor vehicle assemblies posted another sharp gain in August, but the employment report suggested that activity stalled across the rest of the factory sector. In fact, we look for outright declines in output in sectors such as petroleum refining, printing, apparel, food, and fabricated metals. So, the manufacturing category is expected to be up 0.2% overall but down 0.1% excluding motor vehicles. The utility component is expected to be a neutral factor in August, as some elevation during the early part of the month is about offset by hurricane-related disruptions at month-end.
Brazil's central bank's surprise rate cut in late August has raised the question of whether we are now dealing with a different monetary policy framework in Brazil. Although it is possible that the central bank might be accurate in its assessment of the risks of a global recession, the bank appears to be much more comfortable in taking risks than many, including us, had thought. According to the central bank's latest models, the current global crisis is equivalent to roughly one-quarter of the 2008-09 downturn in terms of the growth impact on the Brazilian economy. But at this stage there is no evidence that the central bank's base case of global recession is materialising and, more importantly, there are no signs that credit markets are frozen.
A Dual Mandate?
The central bank's willingness to cut interest rates so soon after hiking leads us to only one conclusion: the central bank appears to be operating under a new dual mandate, where both inflation and growth matter. The move at the last meeting has prompted us to revise our rates forecast to 11.0% by end-2011 and 10.50% in 2012; we had previously expected interest rates to remain unchanged at 12.50% for the remainder of 2011 and 1H12, when the bank would start a 100bp cutting cycle. Although we do not expect to see inflation spiraling ever higher - indeed, we expect inflation to remain below the 6.5% upper limit of the target - we are concerned that the risks are skewed to the upside. And we have adjusted up slightly our inflation forecasts for both 2011 and 2012.
Under our base case in which the developed markets get dangerously close to recession, the Brazilian economy fares quite well, despite some volatility around the turn of the year. While we expect economic growth to slow to a seasonally adjusted annualised pace below 2.0%, this is precisely what Brazil needs to change the course of the current inflation dynamics. As we have highlighted before (see "Brazil: Not Time to Cut", This Week in Latin America, August 29, 2011), although domestic output is softening, we are still seeing robust demand (the Growth Mismatch), which in turn is keeping unemployment at record low levels and inflationary pressures high.
Economic growth does seem to be playing a bigger role in the central bank's monetary policy decisions than it did in the past. Recall that in the bank's March 2011 Inflation Report, when growth was still expected to be around 4% in 2011, the central bank said that the "output sacrifice cost that would guarantee that 2011 inflation would be around 4.5% was excessively high". As global growth prospects worsened in the past few weeks, the bank apparently determined that the output sacrifice cost needed to achieve inflation convergence in 2012 is also too high, and monetary policy has become growth-oriented as a result.
In the absence of a global recession, this means that new monetary stimulus will add new inflationary pressures that we were not expecting. The central bank's job has now become an even more complicated balancing game between achieving a minimum level of growth and a maximum level of inflation. We believe that there is an inflation rate that does cause discomfort for the administration, and if the past nine months serve as reference, it was precisely when inflation expectations were dangerously close to breaching the upper band of the target band - at 6.4% in May 2011 - that we saw the most cohesive anti-inflation speech from the central bank and other administration officials.
Certainly, the central bank sees this less dire scenario - where a global recession is averted - as one possible outcome, although not its base case. The risk that this more benign outcome comes to pass should limit the extent of any rate cuts until it is clear which story will play out. Assuming that the central bank is not willing to threaten the upper band of the inflation target in this alternative scenario, we expect that the monetary authorities will use the full width of the band in order to stay ahead of the curve, based on their most likely scenario of global recession. Using modeling techniques for inflation that are similar to those of the central bank (a small size structural econometric model), we see room for another 150bp of cuts in the short term, without inflation forecasts going above 6.5%.
Working under these new assumptions, we now expect that the central bank will continue to cut rates in the next three meetings by 150bp, with a trough of the Selic rate at 10.5% in January 2012. Under this new rates scenario but adding our more constructive growth profile (relative to the bank's base case), we are revising our inflation forecast for 2012 to 5.9% from the current 5.2%. We had previously assumed that the labour market would soften, reducing (albeit slowly) some service price pressures in 2012. Under the new set of assumptions, we now have service prices edging up from the current 9.0% to 10.5% by the end of 2012. We have also hiked our inflation forecasts for other categories marginally, with the exception of food prices, which we still assume will rise to around 4.5%, given that they are historically more supply-driven. Of course, our forecast is very sensitive to any supply shocks in the food chain.
Premature Cutting
We suspect that the central bank's decision to cut interest rates so quickly may have been premature for three reasons:
First, even if the Brazilian central bank's base case of global recession materialises, inflation will still be high, given the current dynamics. We have little doubt that the net effect of such an adverse scenario would be disinflationary to Brazil, as highlighted by the authorities. Recall that when commodities prices plunged as a result of the global crisis in 4Q08, the Brazilian economy contracted at a seasonally adjusted annualised pace of 15.4% in that quarter, although what most remember is that in 2009 the economy only contracted by 0.2%. If a similar scenario materialised, Brazil would certainly be affected by weaker commodities prices, and despite the fact that the exchange rate would also devalue, the 2008 experience serves as an example of the final disinflationary effect.
That said, even in the global recession scenario, we still do not see 2012 inflation falling much below 5%, given the current inflation dynamics in Brazil. Although it would be a victory to bring inflation from the current 7.2% (as of August) to close to 5.0% in 2012, that would still be higher than the centre of the target band (4.5%), due to the stickiness of service prices and Brazil's backward-looking dynamics - unless food prices correct more sharply than in 2009. The biggest victory in this scenario would certainly be a re-anchoring of inflation expectations, which are now on the rise for as far as 2016, as measured by breakeven inflation.
Second, despite a challenging outlook for global economy, we suspect that the balance of inflation risk is skewed to the upside. Our global team is not calling for a recession, but rather a slowdown, even though it is a bumpy one. Also, it is important to recall that although GDP is softening in Brazil, domestic demand actually accelerated in 2Q, growing above 5%, keeping labour market pressures alive.
Although the central bank attributed almost all the weight of the decision to the global environment, it no doubt carefully considered the role of fiscal policy. The administration has surprised most Brazil watchers with a firm fiscal policy in 2011, but next year the picture is more challenging and clearly not enough to justify a pre-emptive rate cut. We do not expect that fiscal policy will be exceptionally loose, but it will most likely be looser than the current stance. The 2012 budget submitted to Congress has some very positive developments, such as only a 2.5% nominal increase for public servants' payroll. But the overall picture points to fiscal expansion in 2012 with expenditures growing by 16% while revenues would only grow by 12%. More cuts could be made, of course, but the pipeline of possible new expenditures in Congress - such as police force and judicial system workers' wages and healthcare budget expansions - combined with the administration's fragile congressional base does not give us enough confidence despite the improved tone of officials' speeches.
Also, the inflation composition with the less business cycle-sensitive part of inflation - service prices - running this high brings challenges. Even a minor supply shock takes inflation to levels way above the 6.5% upper band of the target. Although we currently do not forecast any of these in 2012, supply shock in food chains such as beef prices in 2010 and milk prices in 2007 easily contribute to an extra 100bp of inflation. This increases significantly the upside risks of inflation. And with Brazil's backward-looking wage negotiations and rents, a supply shock in one year can easily become price pressures in the next.
Finally, in case the central bank's fears of a global recession are proven wrong, the most dangerous effect of the recent change in monetary policy path does not lie in 2012 but longer term. We have long argued that the current inflation dynamics are sticky; this has been the reason behind our above 4.5% inflation forecast for 2012, despite softer growth in production. The same ‘stickiness' argument works in favour of the central bank in 2012, likely keeping inflation from spiraling out of control, especially as the industrial sector is set to get even worse than the flat growth over the previous 18 months.
The real danger lies in the post-2012 expectations. Breakeven inflations are already showing a higher risk premium on inflation, but we are concerned that the survey of economists is also going to start showing a significant deterioration in inflation expectations for 2013. Historically, inflation forecasts that far out tend to be at the centre of the central bank's target, given that market participants believe in the central bank mandate. But daily data for 2013 inflation expectations show that as of September 2 - only two days after the rate cut announcement - the market median expectation moved from 4.5% to 4.6%. We are worried that this is just the beginning of the de-anchoring.
Bottom Line
If the central bank's global recession scenario materialises, we believe that the new rate cutting cycle will lead to an acceptable inflation rate for 2012 and a somewhat less dire growth prospect than would be the case if rates were held constant. That being said, at this point the move seems like a risky choice, given the lack of evidence that a global recession will occur. Under our more benign base case, and inferring from the current administration's behaviour in 2011, we believe that the authorities are committed to keeping inflation from breaching the upper limit of the target band. We think this constraint would limit the current cycle to another 150bp of cuts. This will likely lead to a 5.9% inflation rate in 2012 and further de-anchoring of inflation expectations for 2013 and beyond. Although this does not seem to be an unstable scenario, it carries significantly more risks than the model where the 4.5% inflation target was pursued without the need to insure against a growth slowdown.
During a two-day investor trip to Turkey, we attended a presentation delivered by CBT officials (along with a Q&A session with Governor Basci and the rest of the monetary policy-makers), held meetings with policy-makers such as Finance Minister Mehmet Simsek, the IMF, the US Embassy as well as large private and public sector banks.
We provide a detailed summary of our take from the trip here. In general, we can state that we found the CBT to be highly confident about its current monetary policy stance (and strategy), its view on inflation, its ability to tackle possible escalation in currency weakness and its strong conviction that the current account would soon be improving amid a slowing economy. Our perception was that the CBT placed a significant probability on further weakening in the macro situation in Europe and the likely adverse impact on the Turkish economy, which needed to be tackled by maintaining an easing bias until developments suggest otherwise. We did get the impression that all monetary policy tools could be utilised to address the potential global downturn, but we sensed that the CBT might use the policy rate cut as the last resort while aiming to alter the required reserve ratio (RRR) as the next step.
Our discussions with government officials, the IMF and the US Embassy officials suggest that the fiscal outlook is positive and, while further micro reforms still need to be implemented, the broad picture remains encouraging. The soon to be released 3-year Medium-Term Plan (MTP) will provide a clear picture in terms of the outlook for debt dynamics, while giving better shape to inflation and current account deficit expectations. Most importantly, we have been told that various micro reforms would soon be introduced with the aim of improving Turkey's external competiveness, productivity and encouraging investments in the country to raise the share of domestically sourced inputs to production so that the current account deficit could be lowered gradually. While we were told by government officials that there would be no leniency to deviate from the main fiscal targets of maintaining an easing trend in debt to GDP and lower budget deficit to GDP, the Minister of Finance seems to be ready to address any possible downturn in the economy (on the back of contagion from Europe) by introducing automatic stabilisers on the fiscal side in addition to some selective measures that are mostly revenue-neutral.
The Central Bank of Turkey: Confident with current policy stance but highly concerned about Europe: We attended an extensive presentation at the CBT and we summarise the highlights below.
•· The CBT summarises its view towards growth by stressing the external factors but also pointing to the cooling off in domestic markets as well: "Recent data releases are in line with the CBT's previous assessment that global economic activity continues to decelerate. In addition to weak external demand, there is an ongoing slowdown in the domestic demand since the second quarter."
•· Credit growth has declined below seasonal averages. The CBT stressed its insistence in maintaining the soft goal of aiming a 25%Y credit growth for the year (which is likely to be kept intact in broad terms in 2012). This was not new news. However, there was a ‘nuance'; Governor Basci mentioned that the CBT now wanted loan growth at 25%Y but with a fixed exchange rate, i.e., the headline credit growth rate could be higher, given the weaker currency. Moreover, he stressed that the CBT did not want the credit growth rate to be materially higher or lower than the desired growth rate. Interestingly, our discussions with local banks suggested that exceeding a loan growth rate of 15% might itself be a significant challenge, given the balance sheet constraints imposed by the Banking Regulation and Supervision Agency (BRSA) along with easing demand.
•· All policy tools will be used to address the adverse impact of possible contagion from Europe. Governor Basci was very specific about the tools and the order in which these tools would be used in the future. He mentioned that, as an initial step, the CBT would consider a change in methodology in implementing the RRR and allow banks to place part of the TRY reserve requirements in foreign currencies. He did not mention what portion of the reserve requirement could be kept in FX but our impression was that it would be tested with a small amount in the beginning, to be raised if and when deemed fit. Governor Basci stressed that this change could take place before the regularly scheduled MPC if necessary.
•· What would be the impact of such a change? Our view is that letting the banking sector partially substitute TRY reserve requirements with FX will ease the banking sector's overall need to borrow in the cross-currency swap market and lower short-term rates. This view seemed to be a common one among local banks. The tricky part rests with the impact on the currency: almost all local banks had a different view regarding the impact of the change in methodology on the currency. Some expected weakness, some expected strengthening and some expected a neutral impact. We agreed with the view of one bank, which suggested that it all depended on what portion of the TRY reserves requirements could be allowed to be kept in FX. It seems only plausible to assume that the CBT would start with a low percentage (around 5-10%) and raise the amount as needed, which might have a direct impact on the currency, i.e., the higher the ratio goes, the lower short-term yields would be and, after a certain point, it might cause the currency to depreciate (both due to low carry and banks' increased efforts to accumulate foreign currency).
•· RRR cuts and methodology changes possible, policy rate cut can wait. Our impression was that the CBT seemed ready to ease the RRR on TRY deposits as soon as the upcoming data, especially the monetary policy response by the Fed and the ECB, became clear(er) in the weeks ahead. In our view, the policy rate might be cut only if growth and growth-related data consistently come out soft and the possible contagion from Europe becomes a clear and present danger. In that sense, we maintain our view that the policy rate might be kept unchanged this year while a series of RRR cuts seems likely.
•· Strong fiscal position. The CBT seemed to be fairly content with the performance of the fiscal side as well as the supportive measures taken by the BRSA. According to the CBT, these two had been supportive of the monetary policy mix adopted by the bank. Our discussion with local banks, the IMF and economists broadly confirmed this view and, while some suggested that a portion of the strong revenue performance could have been saved better, it was obvious that the numbers displayed a strong fiscal position.
•· Currency is undervalued. On the currency, the CBT (to be exact Governor Basci) had a very clear stance: The lira is undervalued by 5-10%. According to Basci's remarks, the CBT viewed the recent depreciation in the currency to be a positive change going into any market turbulence since there seemed to be no doubt that the lira has gone through a significant adjustment. Governor Basci stated specifically that the CBT had no commitment to any level or range in the currency but was just expressing its view that the currency was undervalued. In the light of the CBT Research Department's estimations that the current FX pass-through coefficient would be somewhere around 15% (of which 12pp would take place in the first 6-9 months), the bank would be expected to be extra careful about the adverse impact of any further weakness in the currency. In our view, the CBT seems to be broadly comfortable with the current level of the exchange rate, but it has also been mentioned that the bank's estimation of the output gap is now higher than a few months ago, which would place a lid on the potential FX-pass-through rate.
•· The CBT pays special attention to TRY's value against a basket of EM currencies. Considering the period starting from 2006, the value of TRY against emerging country currencies as of August 2011 was 7.1% below the recent low level of March 2009. REER index currently stands at the historically lowest level since its base year of 2003. According to Basci, the currency has gone through significant adjustment already and this could be seen as an advantage heading into any possible turbulence stemming from Europe.
•· Short-term yields should act counter-cyclically. An interesting and fairly straightforward remark that was made by Governor Basci caught our attention. Basci indicated that the monetary authority wanted the short-term (up to two years including the benchmark) T-bill rates to ease when global macro conditions worsened and vice versa such that the yield on T-bills up to two years' maturity would trade in a counter-cyclical manner.
•· Current account deficit will likely decline. On the current account front, the CBT seemed quite convinced that soon the numbers would show a marked improvement on a monthly basis and on a 12-month cumulative basis in 4Q11. It had been stressed during the presentation that the ongoing rise in exports and the gradual decline in imports had been on the back of the currency adjustment, slower growth and lower commodity prices. Specifically, the bank's Research Department mentioned the fact that exports had been approaching the level of non-energy imports, which had been the desired change. Based on the CBT's C/A forecasts for July and August, the seasonally adjusted deficit might ease to a monthly level of US$5 billion. In fact, when the energy component is deducted, the same deficit might ease to around US$1 billion.
•· Inflation is likely to rise temporarily and the medium-term target (5%) is within reach. We would not consider the CBT to be overly worried about inflation in the near term and our impression is that the bank will be accepting some deviation from the target for some time (i.e., no action to correct it), given the conviction that growth would be slowing down and the overall risks from commodity prices (and the FX pass-through) are likely to be contained, given the widening output gap. As we mentioned earlier, Governor Basci specifically pointed out the revised output gap estimates, which are expected to contain upside risks on inflation stemming from FX pass-through.
•· Foreigners maintained their share in government domestic debt instruments: According to the bank, "while the rapid increase in the share of government securities held by non-residents lost the momentum observed in the first half of 2011, the mild interest from non-residents allowed their share to increase to almost 13% in the recent months". The share of non-residents holdings in the total went up as high as 14% during 2007 and gradually declined to as low as 6% in early 2010. Since then, there had been a sharp and decisive rise despite lower rates.
Fiscal picture is stable if not strong: Based on the fiscal realisations in the first half of the year, it is easy to claim that the fiscal picture is quite sound. Our discussions with the fiscal authorities suggest that the performance of the first half was predominantly on the back of strong growth and revenues, which is unlikely to repeat in the second half. That is, there will be a deficit in 2H11. Still, the targeted deficit levels might be undershot, especially in the absence of a major deviation in the coming months of the year. Finance Minister Simsek stressed that the government had two main aims on the fiscal front: keeping the debt to GDP and the deficit to GDP ratios on a downward trend in the coming years. Based on his assessment, any sharp deterioration in growth prospects might be addressed by the fiscal authority via the introduction of the automatic stabilisers along with some selective (targeted) measures that would be mostly revenue-neutral.
Improve competitiveness and productivity to lower structural C/A deficit: According to Minister Simsek, the government will be eager to spend on education, infrastructural investments, high-speed railway, irrigation projects and similar areas that would improve the medium-term productivity and competitiveness of the country. Mr. Simsek mentioned some specific projects that would be introduced soon. These included the Fatih project that envisages a digital platform to be set in classrooms connected with the fibre-optic network where all students are given a tablet computer. Clearly, this would be a high-cost investment but, according to Minister Simsek, incentives will be given for manufacturers to produce these tablets in Turkey. A similar comment was made recently by Deputy PM Ali Babacan, who stated that Turkey would be providing incentives for the manufacturing of engines and similar items that comprise a significant portion of imports. In general, we see the effort and the intentions as positive for the medium term, which seems to be the only way to lower the structural current account deficit.
At what point would fiscal measures be introduced? While Minister Simsek refrained from giving any binding figures, he mentioned that the government would like to maintain the trend growth rate of circa 5% over the years. However, given the state of the global economy, he acknowledged the downside risks and that they could be patient to some extent until the projected rate fell significantly short of this. Our impression was that this threshold could be around 3.5% for next year; anything in that region could see some escalation in fiscal spending.
How do local banks view things: Our discussion with local banks centered on their assessment of the CBT's monetary policy, the loan growth outlook, balance sheet (funding) constraints and the overall state of the economy. We were somewhat surprised that almost all banks equivocally expressed concern about their ability to increase loans, given the constraints imposed by the regulator along with easing demand amid rising loan rates.
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