There are some fundamental factors that fostered the current success in the disinflation program. One important element is the radical improvements in public sector fiscal disequilibrium (i.e., the decline in the budget deficit and the tremendous decline in public sector borrowing requirements parallel to the decline in the public debt roll-over ratio).
The second element is the continuous and high-level private sector fixed capital formation. In other words, the major engine of growth has radically shifted from the public to the private sector.
A third, but presumably the most important, factor is the surge in both labor as well as total factor productivity (TFP). The index of labor productivity increased to 145 from 98 in 2001, and the TFP increased to 45 percent in the final output of 2005 from just below 5 percent in 2001.
Moreover external factors should also be cautiously noted here. A positive international conjuncture promoted foreign capital inflows to the emerging markets such as Turkey -- a process which significantly strengthened the value of the domestic currency (YTL). As we consider Turkey’s high rate of dependency on primary, intermediate and capital goods importation, positive contribution of overvalued local currency becomes more visible. This is important especially because of the record-level increase in commodity and energy prices.
As a matter of fact the midyear turbulence of the 2006, triggered by international financial markets due to major structural weaknesses of the US economy, has shown that Turkey’s ability to withstand inflation is still quite strong. For instance the rise in the 2006 CPI was 9.6 percent -- a tremendous deviation from the target rate of 5 percent -- in which almost 3 percent is calculated as “imported inflation.” A study suggested that in our disinflation program, positive contribution of exchange rates is strongly needed.
Therefore, a steady and stable decline in the value of exchange rates has been determined to be a positive factor in our disinflation program. Obviously due to the so-called “impossible trinity” (you can target only one factor among the inflation, interest rate, and exchange rate) the central bank (CB) would definitely reject any arguments saying that the CB should aim at lowering exchange rates in addition to the CPI.
Even if the external environment has been favorable in Turkey’s disinflation, strengths of the domestic economy in general and a high real interest rate in particular constituted a critical benchmark in attracting almost every kind of net capital inflows to the country.
As a matter of fact, the interest rate level is open to discussion in terms of Turkey’s growth performance, current account deficit and the level of inflation. Nominal interest rates in the Treasury’s major borrowing instruments now seem to hover around 19 percent after declining from around 60 percent in 2002. On the other hand, the ex ante interest rate has been less than 10 percent for the last three years. The question becomes whether or not this level of decline is enough or not.
Having considered Turkey’s path in interest rates and growth performance, there is no rationale for denying sufficiency of the decline in interest rates. As a matter of fact, the levels of interest rates for the last five years did not prevent Turkey’s big push in expanding. Also we all know that growth is bounded by resources. In that regard higher growth would lead to an even larger deficit due to structural bottlenecks, and it would also create further pressure on financial markets due to an ever-increasing savings and investment gap.
(To be continued)
