Turkey: Start Reading About Deflation
Serhan Cevik (London)
You are probably reading the first article discussing deflation in the Turkish economy. In the past three decades, Turkey had endured the devastating problem of high and volatile inflation — a product of political mismanagement and policy backwardness — that turned into a chronic disease distorting the market economy and worsening economic and financial conditions. As the works of Finn Kydland and Edward Prescott, the recipients of this year’s Noble Memorial Prize in Economic Science, have made it clear, a (coalition) government’s failure to demonstrate genuine aspiration to achieve macroeconomic stability has led economic agents to make high inflation a self-fulfilling prophecy in Turkey. However, the crisis and resulting deep recession in 2001 changed many things, including the mother of all problems — political fragmentation. The 2002 election produced the first single party government over a decade, and consolidation of the political landscape has allowed for coherent implementation of structural reforms and sound economic policies. Not surprisingly, the inflationary bias quickly subsided and gave way to a tremendous wave of structural shifts and competitive pressures that have contributed to Turkey’s remarkable disinflation process.
The diminishing risk of political crisis has created a virtuous cycle of expectations. Political stability, institutional reforms(such as granting the Central Bank of Turkey operational independence) and prudent fiscal policies have produced a breakthrough in the country’s (dis)inflation dynamics. The credibility gap, measured by the difference between consensus inflation expectations and the official inflation target, moved from 14 percentage points at the beginning of 2002 to 5 percentage points last year and to 1.2 percentage points at the start of this year. The latest reading of -2.5 percentage points suggests that the ‘gap’ has in fact become a ‘surplus’ of credibility, permitting fundamental factors to have greater influence on economic and financial developments. For example, increased openness — the volume of international trade has risen from 34.6% of GDP in 1999 to 47.2% last year and 51.2%, on our estimates, this year — has lowered mark-ups and supported the country’s productivity renaissance.
The inflation rate, measured by consumer prices, will remain in the single-digit territory. The consumer price index posted a month-on-month increase of 2.2% in October, pushing the twelve-month inflation rate to 9.9% from 9.0% in September, because of a large adjustment in food and beverage prices. Nevertheless, the cumulative increase so far this year in consumer prices stands at 7.2%, well below the 15.5% recorded in the same period last year and the central bank’s year-end inflation target of 12% this year. According to our computations, the CPI registered a seasonally adjusted month-on-month increase of 1.0% in October, which implies an annualised inflation rate of 9.2% over three months, down from 10.6% in September and an average of 19.9% last year. Meanwhile, the wholesale price index rose by 3.2%, due principally to higher energy, farm and administered prices. Consequently, the annual rate of change in the WPI accelerated to 15.5%, from 12.5% in September and this year’s low of 8.0% in March. Farm prices in the WPI basket posted a monthly rise of 6.1% last month, following a 5.5% rise in September. In our view, structural inefficiencies in the agriculture sector and ‘speculative’ fluctuations prior to and during the month of Ramadan account for this abnormal increase in food prices. Indeed, the WPI excluding volatile farm and energy prices increased by 0.9% on a seasonally adjusted basis. Likewise, private-sector manufacturing prices, the widely used proxy for core inflation, increased by 1.4%, or 1.0% on a seasonally adjusted basis, in October. As a result, the annualised inflation rate over three months stood at 12.3%, right in line with this year’s average and down from 14.0% last year.
The disinflation process is much more pronounced in goods than in services. The inflationary bias and inertia in the Turkish economy resides mostly in the non-tradable sectors, such as housing, education and medical services, while the increasingly competitive sectors actually exhibit deflationary tendencies. For example, rents and hospital services posted annual inflation rates of 19.4% and 16.8%, respectively, in October, whereas the headline inflation was just 9.9%. Even though we observe a gradual deceleration in these ‘non-tradable’ service prices on a seasonally adjusted basis, the implied annual rates are still running at more than twice the headline inflation rate and, especially, out of sync with deflationary readings recorded by ‘tradable’ goods. While the prices of goods in the CPI basket increased by a year-on-year rate of 6.9%, the prices of services registered an annual inflation rate 15.3% last month. Looking into sub-categories reveals even more details of this curious disconnect between tradable and non-tradable price adjustments. For example, the year-on-year increases in clothing and houseware prices were 0.8% and -0.7%, respectively, in October. In other words, the year-to-date increase in rents was 15.9%, whereas clothing and houseware prices posted cumulative increases of -0.4% and -1.0% in the January-October period. Given productivity gains and the presence of competitive pressures, this widening gap between tradable and non-tradable prices is not surprising at all and, in our opinion, points to a behavioural change in the corporate sector.
If we take into account technical biases, deflation has already become a reality. Official price indices, based on a survey of consumption patterns in 1994, are outdated in terms of substitution and quality effects, and as a result, may overestimate inflation rates. An independent study of consumption patterns shows that the substitution rate was 23.8% in 2001, 2.1% in 2002, and 1.1% last year. In other words, the official CPI overestimated the true inflation rate by an average of 35.7% in the last three years (see “It’s Lower Than You Think,” March 4, 2004). Even though the economic recovery has made the substitution effect less pronounced, a reversal favouring pre-crisis consumption baskets has not yet taken place. In the meantime, record high oil prices are destroying purchasing power more than creating inflationary pressures. Morgan Stanley’s forecasts indicate a prolonged period of higher oil prices and a deceleration towards US$35 per barrel by the end of next year. So far, higher energy prices have acted like a tax increase, reducing consumer purchasing power, while the improvement in energy productivity cushions against the inflationary impact.
The acceleration of productivity growth has anti-inflationary properties. Many Turkish firms have enjoyed market power allowing a profit maximising strategy based on disproportionate price adjustments (see below). However, as competition spreads through markets, price increases become less and less revenue enhancing, due to the increased price elasticity of demand. The only way for the corporate sector to increase profitability in an increasingly competitive environment is to boost productivity. Indeed, over the last three years, labour productivity has grown at an annualised rate of 9.5%, up from an average of 2.2% in the 1990s (see “The New Economy,” August 17, 2004). Higher productivity, in turn, has effectively lowered the rate of price increases, especially in the tradable sectors by raising potential output and reducing unit labour costs, and added to the upward momentum on output growth, creating more of a disinflationary (and even deflationary) economic boom.
The recovery in final domestic demand remains behind the rise in aggregate supply. The Turkish economy is growing at an above-trend pace, but the recovery in final domestic demand remains well behind the rise in aggregate supply. In fact, we have up to now observed a ‘selective’ increase in private consumption. For instance, consumer spending excluding durable goods, which posted a 55.3% increase, increased by 4.8% in the first half of this year, even after a cumulative rise of just 0.6% in the preceding three years. In our view, productivity-driven jobless growth and a more than 20% drop in real wages have lowered labour’s share of national income and resulted in a demand gap. According to our calculations, the ‘gap’ between aggregate supply and demand has widened from an average of -4.1% of GDP in the 1990s to an average of 7.4% after the 2001 crisis. Though it is narrowing, the demand gap is still extraordinarily high for the Turkish economy and indicates that disinflationary pressures are highly likely to persist in the periods ahead.
The above-trend pace of output growth does not mean the economy is about to hit its speed limit. Turkey’s current business cycle is driven by labour-augmenting productivity and investment growth that has raised its potential growth rate, from 4.0% in the 1990s to about 7.5%, on our estimates. This upward shift in the trend growth rate of potential output implies that aggregate demand needs to grow at higher rates than before in order to cause inflationary pressures. However, aggregate demand is not growing fast enough to absorb higher potential output, and as a result, the output gap — the difference between the current level of GDP and the level that would prevail when factors of production are fully utilised — still points to ‘excess’ capacity in the economy. Moreover, we believe that the continuing investment boom will bring about another upward move in the country’s supply curve and thereby facilitate the disinflation process in the future, despite the strong pickup in economic activity and higher energy prices.
Keeping productivity-driven disinflation on track requires microeconomic adjustments. Turkey’s economic stabilisation programme has so far been exclusively based on macroeconomic strategy and structural reforms in the public sector. Of course, fiscal consolidation and conservative monetary policies are key to the success of the disinflation effort, but we argue that the authorities must also deal with the country’s uncompetitive market structures that are, at least in part, responsible for its inflation problem. Although competitive pressures have forced companies to become more productive, there are still inefficiencies arising from oligopolistic market structures and international trade barriers. For example, the market concentration ratio, based on the shares of the four largest companies in total sales, show that 58.5% of industrial sectors had high or very high degrees of concentration in 2001, up from 51.2% in 1980. Therefore, the next stage of reforms should aim to overhaul the archaic tax system and introduce microeconomic measures to achieve balanced growth through productivity improvement and greater competition and openness in the Turkish economy.
The secular breakthrough in inflation dynamics has important financial implications. Although Turkey’s consumer price index is not consistently negative, many tradable goods have already moved into the deflationary territory. However, this is ‘good’ — benign — deflation, caused by structural changes and driven by productivity gains, and has a number of important implications for the economy and financial markets, in our view. The gradual diminution of inflation and expectations of future inflation should continue to push both short- and long-term interest rates to lower levels. At the same time, lower, more stable inflation will reduce inflation volatility as well as the volatility of inflation expectations, enhancing financial market stability and supporting the acceleration in business capital spending. To boot, the accession negotiations with the European Union will provide another strong ‘anchor’ for policy credibility, pushing Turkey’s risk premium to a lower plateau. To cut a long story short, productivity-driven growth dynamics will hold the secular disinflation process on track and allow the central bank to keep recalibrating the monetary policy stance.
morganstanley.com |
