In her confirmation hearing before the Senate Banking Committee on Thursday, nominee for chairwoman of the Federal Reserve Janet Yellen indicated that the current Fed policy of near-zero interest rates and large-scale asset purchases could not go on indefinitely. She gave no indication of a specific timeframe, but stated that the Fed will continue to evaluate whether the time is right to tighten policy on meeting-by-meeting basis.
The Fed’s policy of quantitative easing has had significant implications for the economies of emerging market nations. With US treasury bonds offering near-zero yields, investors have turned to other assets with higher returns. This has increased demand for the sovereign debt of nations like Turkey, Brazil, and Indonesia, who are considered fiscally stable but still offer much higher yields than US debt. Indeed, Turkish borrowing costs fell steeply in the wake of the financial crisis, in part due to low yields elsewhere. On the eve of the financial crisis, in July 2007, Turkish 1-year bonds had an incredibly high yield of 18%. By August 2009, 1-year yields had fallen to about 8% and have remained near that level since then. This influx of foreign capital has been a boon for countries like Turkey, allowing them increase private sector investment and cheaply raise funds for public development projects.
Turkish banks have been taking advantage of low long-term interest rates by issuing large quantities of dollar denominated bonds to foreign investors. Turkey has also sought to use abundant foreign capital to fund ambitious infrastructure projects, like a new 22 billion euro airport, intended to be the largest international flight hub in the world. Many are concerned, however, that Turkey has become too reliant on capital inflows that could evaporate if interest rates in Western nations begin to rise. The viability of the new airport and other infrastructure projects has been called in to question by observers who expect Turkey’s borrowing costs to rise as the Federal Reserve tightens monetary policy. Morgan Stanley analyst James Lord raised the profile of these concerns in August when he declared Turkey to be a member of the “fragile five,” five emerging market nations that are viewed as especially vulnerable to credit market readjustments.
In October, the IMF warned that the coming rise in interest rates may already be causing investors to move money out of Turkey, raising borrowing costs and contributing to the depreciation of the lira. The IMF report urged Turkey to reign in government spending and tighten monetary policy, so that Turkey is not left with an unsustainable level of foreign debt when interest rates rise. Another area of concern is Turkey’s large current account deficit. Currently, much of its domestic consumption consists of imports financed by foreign capital. If the lira depreciates further, the relative price of imported goods will rise, possibly at the same time as borrowing costs rise due to reduced demand for emerging markets debt.
Still, there is reason to be optimistic about the future of Turkey’s economy. A January 2013 paper by the Federal Reserve Bank of New York found that a 10 basis point reduction in Treasury bond yields results in only a 1.7 basis point reduction in the yields of emerging market debt. This suggests that low borrowing costs in Turkey may be an organic result of confidence in the Turkish economy, and cannot be fully explained in terms of a search for yield by foreign investors. If the correlation suggested in the paper holds when interest rates are rising as well, a massive jump in US rates from near-zero to 5% would only raise Turkish borrowing costs about 1%.
Furthermore, the Turkish central bank has recently been moving to reign in the economy and prevent the lira from sliding as fears of capital flight grow. They announced Tuesday that they would temporarily halt a program that offered short-term loans to banks, hoping to gently reduce the availability of cheap credit and curtail inflation. This is an important step in the right direction; it will likely raise interest rates and increase private sector saving. Essentially, raising the prevailing interest rates now prevents the central bank from having to raise them sharply and suddenly later if the Federal Reserve does the same. It should also help reduce inflation, which is currently around 7%, well above the central bank’s target of 5%.
The key question going forward is whether Turkish policymakers will be willing to bear the political costs of reducing inflation and dependence on capital inflows. In the face of the upcoming election in 2014, Prime Minister Erdoğan will likely feel immense pressure to maintain the strongly pro-growth policies that he has built his reputation on. These policies have produced real prosperity gains in Turkey, but rising inflation and uncertainty about the effects of a Federal Reserve taper necessitate tighter monetary policy and a move away from investment financed by foreign borrowing. It is unclear exactly what effect higher global interest rates will have on Turkey’s economy, but Turkish policymakers cannot afford to simply wait and react.
By Caleb Pearce