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Turkey: Inflation Challenges 'Unorthodox' Bank Policy

Monday, 6 Jun 2011 | 5:27 AM ET

While its stock exchange was a shining performer last year, Turkey is now facing the reality of an unorthodox monetary policy that is failing to gain traction. It comes ahead of an important election on June 12, and raises some serious concerns among foreign investors as to whether the world’s 17th biggest economy is overheating.

Istanbul's Arasta Bazaar
Maremagnum | Photographer's Choice | Getty Images
Istanbul's Arasta Bazaar

The highly-anticipated data from the Turkish Statistics Institute on Friday showed that consumer prices rose by 2.4 percent in May from 4.3 percent a month earlier, amounting to 7.2 percent on the year. The market was looking for around a 1 percent build for the latest figure.

The jump was mostly attributed to higher food prices, which rose 12.6 percent compared with the same month last year, and the Central Bank of Turkey (CBT) said on Monday that it expected inflation to come down in June as fruit prices fall.

Usually a popular currency for the carry trade, the Turkish Lira (TRY) came under renewed selling pressure, while bond prices dropped and yields rose.

The CBT is pursuing what has been labeled an “unorthodox” monetary policy, essentially keeping benchmark interest rates low to deter speculative inflows, while concurrently hiking the reserve rate requirements (RRR) to keep loan growth in check. It's done so five times now since November of last year, and that has been received with considerable skepticism in the market.

“The increase in RRRs has not shown its effects imminently on the slowing of loan expansion as expected”, a senior analyst at an investment bank in Qatar told CNBC.

The latest inflation numbers come after trade deficit numbers indicated a less than expected expansion of $9.1 billion in April. But worries about the current account deficit remain. The Organization for Economic Cooperation and Development (OECD) said last month the current account deficit could widen to 8.7 percent of GDP this year, with some analysts even touting the 10 percent mark.

“Given the fact that 70 percent of the deficit is financed by hot money or short-term syndicated loans, Turkey is extremely vulnerable to credit crunches, sudden withdrawals of funds from EM, or the unavoidable Fed tightening,” Egeli & Co. Asset Management wrote in a letter to clients.

Reflecting a surge in domestic demand, bank loans in Turkey grew 35 percent on the year to May 20, far off the CBT’s 25 percent target. The central bank maintained in late May that the impact of the measures on credit growth and domestic demand has become “more visible in the second quarter”.

As much as the inflation data piles the pressure on the CBT to move on rates in the second half of the year, Dilek Yardim, senior country officer for Turkey at Credit Agricole CIB, remains cautious.

“One should not be over-concerned with one data point. The CBT would wait for post-elections fiscal tightening announcements,” she said.

With the Lira weakening the cost of imported goods becomes more expensive, fueling inflation further. Turkey imports 95% of its energy needs, and the recent rally in oil prices has also been cause for concern. On Friday, the Istanbul Stock Exchange lost 0.48 percent, while the iShares MSCI Turkey Index followed later with an 0.15 percent drop.

Another rate decision opportunity would come on June 23, just under two weeks after national elections. The ruling Justice and Development Party (AKP) are seen as favorites, but it is unclear whether they will be able to attain a legislative majority, which would make it easier to push through reforms.

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