The Turkish financial markets were very turbulent in May. As we were preparing the Conjuncture section the dollar had appreciated by 14 percent since the end of April and was trading at over YTL 1.5. Interest rates on the secondary bond market had risen by two percentage points to 16 percent during the same period. The stock market indices had fallen. There was no indication as to when this turbulence would end.
In fact, it was not only on the Turkish financial markets that there was turbulence last month. There was turbulence on most developing countries markets as a result of the rise in the price of oil and concerns abut international liquidity. But the greatest turbulence occurred in our country, which suggests that local factors also played a role in the volatility in Turkey.
The reasons for the turbulence
These local factors include reasons related both to the economy and to politics. The main economic factor is that inflation appears to have begun to deviate from the targets set by the Turkish Central Bank. Inflation rose slightly during the first quarter of the year but it did not unsettle the markets because it had been foreseen by the Central Bank. But, just when the Central Bank was expecting inflation to fall from April onwards, it went into reverse and rose more than over the previous three months. It was already clear that it would not be possible to achieve the target for inflation this year but this increase led to concern that inflation would also exceed the Central Bank’s estimate. This was immediately reflected in expectations and the forecasts for year-end inflation were raised by 0.5 percent. In late April, in the second of the Central Bank’s twice monthly survey of expectations regarding inflation, the forecast for year-end inflation was 5.79, but this had risen to 6.27 percent by the first survey of May.
The presidential election
The most important political factor affecting the markets is the forthcoming selection by parliament of a new president and the resultant increase in tension between the government and the opposition. The ruling JDP has a large enough parliamentary majority to choose whoever it wants as president. This increases the possibility of the next person to occupy the presidential palace in Canada will be someone who is ideologically close to the JDP ideology and this alarms the secularists. In order to prevent this from happening, the opposition, led by the RPP, is pushing for general elections to be held before parliament chooses a president. The JDP is resisting calling early elections and the fact that it has not done anything to alleviate the concerns of the secularists has increased the political tension.
Last month’s attack on the Council of State came when tensions were already high and meant that they rose still higher; and this generated concerns among investors both inside and outside Turkey about the near future.
The pass-through effect on inflation
Fluctuations in the foreign exchange rates have always been amongst the most important factors affecting inflation in Turkey. Research has shown that the implementation of a floating exchange rate regime reduces but does not completely remove the pass-through effect on inflation. In such a situation, if the rapid appreciation of foreign exchange lasts for a significant period of time then we shall see an additional rise in inflation in the months ahead. This prognosis has been strengthened by announcements by automobile producers that they are preparing to announce price increases.
A rise in prices as a result of the increase in the exchange rate will reduce consumers’ spending power and have a constraining impact on domestic demand. In addition, the rise in interest rates will be reflected in credit rates and this will serve as a further constraint on domestic demand. If the fall in domestic demand cannot be offset by exports then there will be a negative knock-on effect on growth. This will make it difficult not only to achieve the 5 percent target for inflation but also the 5 percent target for growth.
This turbulence is different
Since the introduction of the floating exchange rate regime after the 2001 crisis we have also witnessed other periods where exchange rates have risen rapidly in a short period of time. The most recent was in April and May 2004. But on these occasions the increase in exchange rates proved to be short-lived and, because domestic demand was weak, producers were reluctant to hike prices.
Even though it is difficult to say how long the latest increase will last, it is clear that domestic demand is stronger than it was in the previous times of turbulence. It looks as though this strong demand will make it easier for producers to hike prices. This also suggests that the most recent turbulence on the financial markets has the potential to produce more serous economic consequences that the previous ones.
THE CURRENT ACCOUNT DEFICIT CONTINUES TO GROW
A secondary cause of the turbulence on the financial markets in May was the fact that the current account deficit has continued to grow this year. According to the balance of payments figures published by the Central Bank, the widening of the current account deficit did not slow down in the first quarter of this eyar.
According to the above-mentioned figures, the current account posted a US$8.6 billion deficit in January-March. The current account deficit was US$6.2 billion in the same period last year. The increase in the current account deficit over the first quarter thus stood at 39.2 percent.
When one looks at the cumulative 12 month figures, one can see that the current account deficit was US$25.5 billion for the year to end-March 2006. This figure was US$24.9 billion at the end of April.
The current account deficit is a product of the foreign trade deficit. The fact that imports increased faster than exports meant that the foreign trade deficit grew by 39.6 percent over the first three months of the year. There was no major difference in the balance of services or investments compared with last year. The surplus in services grew by 3.7 percent, while the deficit in investments fell by 1 percent.
The continuing growth of the current account deficit has heightened concerns in the business community, but servicing this deficit does not appear to pose any problems. On the contrary, it is striking that the quality of the financing is continuing to improve.
In the first quarter of the year, the capital and finance account posted a surplus of US$14.7 billion. This was US$7.1 billion more than the current account deficit, which produced an increase of US$7.1 billion in the reserves.
Portfolio investments, which are one of the main items in the capital and finance account, declined compared with last year but there was an increase of 102.6 percent in direct investments and a rise of 118.5 percent in other investments, which indicate an improvement in the quality of the financing of the current account deficit. A large proportion of the increase in other investments was the result of the private sector securing long-term credits from foreign sources.