The Fed and the ECB: Close Cousins or Distant Relations? (Part II)
March 07, 2007
By Joachim Fels | London
Two-Pillar Strategy Versus ‘Looking at Everything’
The perhaps greatest difference between the Fed’s and the ECB’s monetary policy strategy is that the ECB puts a special emphasis on a detailed analysis of money and credit aggregates in gauging longer-term risks to price stability, while the Fed has long de-emphasized these aggregates as guides to policy. As Chairman Bernanke said in his speech at the Fourth ECB Central Banking Conference on 10 November 2006: “It would be fair to say that monetary and credit aggregates have not played a central role in the formulation of U.S. monetary policy since that time [1982], although policymakers continue to use monetary data as a source of information about the state of the economy.” However, while money plays a prominent role in the ECB’s official strategy, the differences between the ECB approach and the Fed’s approach should not be overemphasized, for several reasons. First, while the ECB regularly scrutinizes monetary developments in great detail, it also scrutinizes a broad range of all other indicators (subsumed under the so-called ‘economic’ pillar) that might have a bearing on inflation. Thus, like the Fed, it is ‘looking at everything’, including monetary and non-monetary factors. Second, given that the euro area banking sector, as opposed to securities markets, plays a much larger role in financing the economy than the US banking sector, it would seem natural that money and bank credit developments are more informative for the ECB than the Fed. Third, to some extent the ECB’s emphasis on money when formulating its strategy in 1998 reflected the attempt to transfer some of the credibility of the Bundesbank, which operated a money supply target, to the new institution. Moreover, just as the Fed experienced a breakdown of the traditional relationships between money, real activity and inflation since the early 1980s, the ECB may make a similar experience in the next several years. In the US, the relationships apparently broke down because of the rapid deregulation of the financial sector, financial innovation, and the related disintermediation of banking services. As Europe’s financial sector integrates and transforms in the coming years, the ECB may witness a similar instability in the money - economy relationship. Needless to say, this would not imply that the monetary analysis becomes meaningless, but it would become ever more difficult for the staff and the ECB Council to extract the relevant signals from money and credit aggregates. ‘Monetary Activism’ Versus ‘Steady Hands’? Conventional wisdom has it that the Fed has pursued a more activist interest rate policy than the ECB, especially in response to negative shocks. Since 2000, the Fed funds rate came all the way down from 6.5% to 1% and has since backed up again to 5.25%. By contrast, the ECB reduced the refi rate from a peak of 4.75% to 2%, to then gradually raise it to 3.5%, with another increase to 3.75% virtually pre-announced for the March 8th Council meeting. Also, when measured against our estimate of the time-varying neutral interest rates for both regions, the Fed has varied its monetary policy stance more aggressively than the ECB since 1999. The Fed pushed the Funds rate further above neutrality (resulting a so-called positive interest gap) in 2000 than the ECB, and in the following recession cut rates further below neutrality (resulting in a negative interest rate gap) than the ECB. It would be premature to conclude, however, that this implies the FOMC has been more trigger-happy than the ECB Council, or that it attaches a higher weight to economic growth rather than inflation. Rather, the larger variations in the US monetary policy stance over the past decade likely reflect the different size and mix of the shocks hitting the US and the euro area, as well as the different structural features of US and euro area labour and product markets. A case in point is the episode from 2001 to 2004 following the bursting of the TMT bubble, which was a negative shock of about equal size for both the US and the euro economy. However, the US experienced at the same time a positive supply shock to productivity, which had started in the mid-1990s and was still in full swing in the early years of the new millennium. The combination of strong productivity growth, which reduced unit labour costs, and a sharp slowdown in demand pushed US inflation sharply lower towards the lower end of the Fed’s “comfort zone” and thus both encouraged and required the Fed to cut interest rates aggressively. Europe did not enjoy a positive productivity but a negative one instead. This, together with the negative demand shock and fairly rigid product markets (and some other adverse shock, for example to food prices) produced a mini-stagflation -- weak growth with inflation above the 2% ceiling. With European inflation higher and more sticky than US inflation, the ECB simply had less leeway than the Fed to reduce rates aggressively. Thus, the lower degree of activism on the side of the ECB did not necessarily reflect different preferences or a different reaction function of the Council members. A more plausible tale is that the “steady hands” policy was due to the features of the shocks hitting the economy and the inherent rigidities. Put differently, if Alan Greenspan had been in Wim Duisenberg’s and then Jean-Claude Trichet’s seat during that period, he would probably not have conducted a vastly different monetary policy. And conversely, if Jean-Claude Trichet was at the helm of Fed, he would probably not do things much differently from Ben Bernanke and his colleagues. Indeed, if productivity in the US is now permanently downshifting from its strong pace of 1995-2005, as I suspect it is, the Bernanke Fed, like the ECB in 2001-2004, would be faced with stickier inflation in the next downturn than the Greenspan-Fed in the previous one, and would thus probably be unable to cut interest rates as aggressively as in the previous rate cut cycle. Highly Predictable, Perhaps Too Much So Another important element of any monetary policy strategy is the way a central bank communicates with markets and the public at large. The Fed and the ECB both communicate frequently and extensively with their various constituencies, both regarding their objectives, their views on current economic conditions, the outlook for economic growth and inflation, and the risks surrounding this outlook. Of course, their styles differ: the Fed relies more on speeches by FOMC members, a short communiqué following rate decisions and publishes FOMC meeting minutes with a three-week delay, while the ECB holds a monthly press conference with Q&A and publishes a detailed Monthly Bulletin. But by and large, both central banks provide a wide range of information that helps markets to understand their strategies and monetary policy decisions. Moreover, regarding their near-term policy decisions, both the Fed and the ECB have been perfectly predictable in recent years. This is because both make use of ‘code words’ to give markets indications about their policy inclinations in the run-up of policy decisions, such as the ECB’s “strong vigilance” phrase that has indicated a rate hike at the next policy meetings. The ECB’s and the Fed’s high predictability stands in sharp contrast with the Bank of England’s or the Bank of Japan’s recent practice of surprising markets with their decisions to hike or not hike interest rates. In my view, the ECB and the Fed have probably gone too far down the route of signaling their next step in advance. While central banks should not aim at wrong-footing markets deliberately, extensive near-term signaling is likely to have contributed to excessive risk-taking in frothy financial markets over the last few years. Ultimately, what matters for central bank credibility is not the near-term predictability of interest rate moves, but their ability to deliver on their stated objectives, such as price stability. Conclusion: Close Cousins The Fed’s and the ECB’s monetary policy strategies are more similar than generally perceived. Both central banks put price stability first, despite the Fed’s congressional mandate of looking at both price stability and growth. The ECB’s numerical definition of price stability is not very different from the Fed’s unofficial ‘comfort zone’ for inflation. Both central banks put much (perhaps too much) emphasis on signaling the near-term interest rate decisions in advance. And, the reason why the Fed has appeared more activist in moving interest rates around than the ECB has more to do with the different mix of shocks hitting the two regions and the different structures of the economies, rather than different preferences or reaction functions of those in charge of monetary policy. Thus, while the two central banks’ styles differ, largely reflecting the different political-institutional backdrop and their different histories, their monetary policy strategies are very similar in substance.
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Views from Prague
March 07, 2007
By Pasquale Diana | London
In a recent trip to Prague, we met with a private sector economist, representatives of the CNB research department and two MPC members. Please find the main findings of our trip below. Summary: there is cautious optimism on the new government's willingness to rein in the budget deficit, although more details on expenditure-cutting measures are needed. On the inflation front, the downside surprise to Jan CPI was largely due to change in CPI weights, which raises the possibility that CPI inflation might be structurally lower in the future. Euro adoption in 2012 is viewed as feasible assuming the government provides a clear roadmap. Discussion on a possible change to the 3% inflation target is ongoing, though a change in the immediate future looks unlikely. We continue to see limited scope for rate hikes this year, to 3%, with the first 25bp hike in July and the second in Q4. Risks to our rate view appear skewed to the downside. Fiscal policy: a concern, but a fading one The Czech fiscal position has deteriorated over the past few quarters, as a recent IMF report also highlighted. The fiscal reform of 2004, which introduced medium-term fiscal targets using nominal revenue projections to determine expenditure ceilings, worked well in 2004 and 2005, but fiscal policy loosened significantly in the run-up to the 2006 elections. The budget deficit likely printed at around 3.5% of GDP in ESA-95 terms in 2006, and looks set to widen in 2007, to around 4% according to the CNB (and 3.9% in 2008). The fiscal slippage is due to the fact that strong growth and revenues were used to revise upwards the spending ceilings, leading to a widening of the deficit. More constructively, however, it was noted that the newly formed ODS-led government appears determined to bring the deficit down to 3%-of-GDP deficit already in 2008 (two years earlier than previous MoF projections), though they have thus far offered no details on how they plan to achieve this. One issue that complicates budget deficit forecasts and projections of the "fiscal thrust" (how much fiscal policy adds to growth) is reserve funds. These are funds that ministries have not spent and are allowed to carry over to the following year. These funds, which amount to roughly 1% of GDP per year (the total stock is worth approximately 2.5% of GDP), legally belong to the ministries, and can be spent at any time. Therefore, they introduce greater uncertainty into the analysis of the fiscal stance. The CNB estimates that fiscal policy added 0.3%pts to growth in 2006, and that it is set to add 0.7%pts this year. Next year, the fiscal stimulus is forecast to be lower, at 0.2%pts. Overall, we sensed a recognition by the CNB that the fiscal situation could be improved, but also that it is far from dramatic. The new government could easily lower expenditures by over 1% of GDP without hurting the economy and, although the pension reform has not been passed yet, the pension system remains in surplus for now. Overall, there is a perception that the new government's proposals to reduce spending, while still lacking in detail, are going in the right direction. For sure, the CNB did not sound as concerned about fiscal policy as it was in the second half of 2006, when it raised rates partly due to fiscal concerns. In addition, while the lack of a clear parliamentary majority for the ODS government is a concern, the Social Democrat opposition might decide to support at least some of the budget reforms. January inflation a surprise, but outlook unchanged The bank's opinion is that most of the 0.2-0.3% downside surprise in January inflation was due to the effect of the new CPI weights. The CNB research department argues that, while higher weights for tobacco will add roughly 0.1% to the current forecast for 2006 (prepared using the old weights), the higher weight of high-tech goods (traditionally in deflation territory and exposed to international competition) might imply a structurally lower inflation rate in the medium-term. At present, however, slightly weaker CZK and higher external inflation risks offset the downside risks to the projection coming from the low Jan CPI (ie, the CNB sees inflation risks as balanced). The CNB's main focus remains on monetary policy inflation (ie, CPI net of tax changes), rather than headline CPI. While this measure is not published on a monthly basis, it is found in the inflation report. The latest projections show this measure of inflation below the 3% target throughout the forecast horizon, and reaching 3% only at end-2008. Euro plan: wait and see Perhaps one of the most interesting discussion points was euro adoption in 2012, a target date recently suggested by the Czech MoF (but not yet official). The clear impression we got is that the CNB would like to see some clear indication of fiscal reforms and a commitment by Parliament before fully endorsing any date. What seems likely, however, is that once concrete fiscal measures and a credible euro target are announced, the discussion on the CNB's inflation target, which is ongoing, will intensify. The current target is 3% (+/-1% tolerance band). While this discussion is valid irrespective of euro adoption, a clear and credible euro adoption target recognized by the CNB could lead to a revision of the target to 2% (+/- 1%), to maximize the chances of meeting the Maastricht criterion. Overall, our sense is that this is unlikely to happen in the near term, though it would not be inconceivable. Rate outlook unchanged: limited tightening this year, to 3%. Risks skewed towards less tightening Following our trip, we think that there is no reason to change our rate forecast, which sees a total of 50bp of tightening this year, starting with a 25bp hike in July. The bank should not be unduly concerned by the negative rate differential with the ECB reaching yet another record of 125bp (as the ECB raises rates this Thursday). Our conversations highlighted that financial stability considerations (credit expansion, money growth) are more important to the CNB than the absolute level of ECB policy rates. The CNB currently views monetary conditions slightly looser than assumed in the inflation report, due to a weaker CZK. That said, there is no urgency to move rates either way, and we believe that this situation will prevail at least until mid-year. In the summer, assuming inflation stays on its forecast upward trajectory, the bank should start to see core inflation approaching its 3% target at the 12-18 months monetary policy horizon. Absent another bout of CZK strength like the one we saw in Q406, this should be enough to trigger a summer hike by the CNB, followed by another increase in Q4. Note, however, that the CNB is assuming a rather steep rise in ex-tax inflation (currently around 1%) over the next two years, which relies on a fast rise in import prices and broad stability in CZK. We view risks to the currency skewed towards CZK strengthening, and risks to inflation tilted to the downside. Therefore, risks to our CNB call are skewed towards less tightening.
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The Wrong Sort of Growth
March 07, 2007
By Gerard Minack | Sydney
December quarter GDP surprised on the upside, but not in a pleasant way: the economy remains unbalanced and, running at full capacity, may need further policy restraint. There are three factors that could accelerate growth through 2007: 1) a revival in business investment; 2) the long-awaited pick up in mining export volumes; and 3) the drought breaking. If all three eventuate, it seems likely that the RBA will have to again tighten policy. There are, however, risks to all three of these possibilities. Moreover, the household sector’s finances remain a concern – although it will require labour market weakness to bring those concerns to the surface. December Quarter: Quirks and Imbalances GDP increased by 1.0% in the December quarter (0.5% expected), to be 2.8% above year ago levels (2.0% expected). Two factors contributed to most of the upside surprise: - consumer spending: up 1.2% in the quarter, contributing 0.7 points to GDP. This strength was in part pay-back for the petrol/banana price squeeze seen earlier in the year. Households lifted nominal spending by 1.4% in the quarter, compared to an average of 1.6% in the prior three quarters. However, prices only increased by 0.2%, producing a pop in real spending.
- public sector capex: up 9.4% in the quarter, contributing 0.4 points to GDP. This is a volatile item, and this strength is unlikely to be repeated.
The bigger picture point is that growth remains unbalanced. Domestic final demand increased by 3.7% through 2006, but unlike in the prior two years this was not business investment-led strength. The contribution to growth from business investment was effectively zero once allowance is made for the drag from imported capital goods. This underscores a point I noted in my comment on last week’s current account data (“A Rant on the Current Account”, March 2, 2007): the external deficit does not reflect capacity-expanding investment imports. Despite the diminishing role of capital imports, imports were a bigger drag on growth in 2006 (cutting GDP by 2.1 points) than in 2005 (1.7 points). The final point to make about growth last year is that the household sector continues to stretch itself to maintain spending. The decline in the saving rate added 0.4 points to growth through last year, seemingly ending (for now) the process of saving re-balance. Associated with the slip in the saving rate is a pick-up in home equity withdrawal, which is now running at over 4% of income. I’ve been dead wrong on calling consumer capitulation in Australia. However, the ongoing negative saving rate, the penchant for debt, and the surging debt-service burden – now 11.4% of income, up 1.4 percentage points over the last year – all suggest that the sector would be very fragile in the face of a weakening labour market. But we’re yet to see that. 2007 Outlook The economy is clearly running near full capacity. In fact, it’s arguably operating at above full capacity, but the unsustainable 3.7% growth in final domestic demand is for now spilling over to imports, rather than inflation. There are three factors that could accelerate activity through 2007. I’m to some extent skeptical about all three, for the reasons explained below, but the simple point is that if even one of them delivers, then it could push the RBA to tighten again. Here are the three putative positives looming on the horizon: - a revival in business investment. As noted last week, the first set of corporate forecasts for FY2008 point to a pick-up in spending. There are two points to make about this. First, these early estimates are subject to at times substantial revision. Second, and more to the point, these are forecasts of nominal spending. Historically the price deflator for investment spending has been very low (so nominal and real track each other closely), but that may not be the case now. That’s particularly a risk as the only source of investment spending strength was mining, which is clearly facing sharp price increases.
- stronger mining export volumes. The non-appearance of mining export strength was arguably the second-biggest disappointment in 2006 (after the soft investment spending out-turn), but the prospects seem far better for expansion in 2007. I have factored double-digit mining volume growth into my forecasts. But in terms of impact on the domestic economy the point to note is this: we’ve already seen the big windfall. As is almost always the case, the big income kick from mining comes from price gains, not volume gains.
- the drought breaking. It’s been raining lately, so this looks likely to be right.
Putting these factors together, it seems likely that they could push growth to above-sustainable levels unless something else in the domestic economy gives way. The most likely candidate is consumer spending, but that seemingly will require labour market weakness. That remains a risk, but we’ll need the data to confirm the story. Market Impact While I don’t think today’s data will have a big impact on RBA thinking, the Bank will be well aware of the possible boost to growth coming from the factors noted above. With capacity tight, and inflation high in the Bank’s target range, the risk is clearly for further rate increases. This is a macro environment that is not adverse for margin expansion, but we are now starting to see typical late-cycle issues emerge – notably pressure on costs. While margins hit a new all-time high in the December quarter, that was partly assisted by the fall in energy prices.
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Downgrading 2007 GDP Growth
March 07, 2007
By Chetan Ahya | Mumbai
Summary The growth environment has continued to worsen post the change in government and continued political uncertainty. GDP data released for the quarter ended December 2006 confirmed the continued slowdown in the growth trend in Thailand. Indeed, growth is decelerating faster than our expectation. In our view, growth conditions are unlikely to improve significantly in 2007. We have been highlighting the downside risks to our estimates for the last three months. With continued deterioration in the macro environment we are cutting our 2007 GDP growth estimates to 4.3% from 4.5% earlier. Thailand will record the slowest growth in the SE Asian region. Domestic Demand Continues To Weaken Domestic demand in the economy continued to weaken, underpinned by growing political uncertainty and slipping consumer and business confidence levels. Consumer confidence, which recovered marginally after the coup, slipped further to 79.9 in January compared to 82.4 in December. In addition, private consumption continued to trend downwards as is reflected in the movement of various consumption indicators. The passenger car and motorcycle sales contracted further to -10%YoY and -17.9%YoY in January (vs. -15.8% YoY and -16.7%YoY in December). Consumer goods imports remained in negative territory at -1.9%YoY in December while the composite consumption index was flat in January. The private investment trend also worsened, with commercial vehicles sales contracting to
-27.8% YoY in January after accelerating to 20.8%YoY in December. The capital goods imports also slumped to a more-than seven-year low of -20.8%YoY in December compared to -6.8%YoY in the previous month. Growth Recovery Likely To Lack Vigor In Absence Of Stable Politics We believe political uncertainty has increased further in the past month. Somkid Jatusripitak, the economic adviser to the military-installed government recently resigned less than a week after his appointment. Deputy Prime Minister and Finance Minister Pridiyathorn Devakula also resigned, citing disputes between cabinet ministers as the reason for his exit. The political insurgency in Southern Thailand also continues to pose downside risks to stability. We believe these factors will weigh adversely on consumer and business confidence in the economy. External Demand Unlikely To Provide Much Support Despite the slump seen in domestic demand in the past 12 months, the relatively healthy growth in the external demand sector has been instrumental in maintaining headline GDP growth at moderate levels. However, in a scenario where global growth and trade could moderate over the next 12 months, export growth is likely to decelerate further. Moreover, we believe the lagged impact of the strengthening baht will only add to the problem. The Thai baht has appreciated close to 13.7% in 2006 against the dollar and by around 4.6% in YTD. On a REER basis, the Thai baht moved to a nine-year high as of January 2007. Fiscal Spending Likely To Remain Moderate Until 4Q2007 With external demand likely to weaken and domestic private sector demand slowing, we believe that the government can avoid major downside risks to growth by pursuing expansionary fiscal policy. The interim government has approved a FY2007 expenditure budget at THB1.57 trn, which marks a 15.1% YoY increase over the FY2006 budget, as well as a widening in budget deficit to THB146bn in FY2007. However, we believe any meaningful rise in spending on large new projects including the mega projects is unlikely to start before 4Q2007 considering the typical time lag involved in pre-execution preparation of such projects. Monetary Accommodation to Cushion Economic Growth Although late, the Bank of Thailand has finally started cutting interest rates. It cut the policy rate for the second consecutive time in its February monetary policy meeting. This brought the policy rate (one-day repurchase rate) down to 4.5%. We believe that sluggish domestic demand and easing inflation will likely provide the BoT with maneuverability to cut rates further. Indeed, inflation has been moderating, with the latest data point indicating inflation decelerating sharply to 2.3%YoY in February, the lowest since March 2004. The BoT believes that "inflationary pressures were expected to be on a downward trend and core inflation should remain within the target range". We expect the BoT to lower policy rates to 4.0% by year -end. This cut in interest rates will reduce the downside risks to domestic demand in the second half of 2007. 2007 GDP Growth Outlook Remains Unexciting We believe growth conditions are unlikely to improve significantly in 2007. Accordingly, we cut our 2007 GDP forecast to 4.3% from 4.5%, based on our expectation of slower consumption and investment growth undermined by domestic political uncertainty. Although, we finally see an effort on the part of the policy makers to revive the sentiment by relaxing the capital controls further and cutting policy interest rates, we believe there is unlikely to be meaningful revival in the growth trend over the next six to nine months.
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January Trade Balance Narrows
March 07, 2007
By Chetan Ahya | Mumbai
January export growth below expectations: Export growth accelerated to 8.9% YoY in January following an increase of 6.2% YoY in December. This was below market expectations. Import growth on the other hand picked up sharply to 17.6% YoY (vs. +2.3% YoY in December). On a sequential basis, both exports and imports contracted to -10.5% MoM and -1.4% MoM (vs. +2.1% MoM and -3.1% MoM in December). Consequently, the trade surplus stood at US$1.9 billion in January (vs. US$3.3 billion in December). Key trends in export segments: Exports of electrical & electronic products rebounded to 8.8% YoY in January compared to 0.9%YoY in December. Exports of palm oil & palm oil-based products also accelerated to 31.6%YoY in January. However, export growth in crude petroleum and petroleum products contracted to -27.9%YoY and -34%YoY in January. In terms of market destinations, exports to EU rose 19.0% YoY (vs. +17.3%YoY in December). However, exports to US and Japan contracted to -5.7% YoY and -2.6% (vs. -2.2%YoY and +5.7%YoY in December), respectively. Import growth momentum remained buoyant across all categories: By end-use classification, capital and intermediate goods imports accelerated to 21%YoY and 18.5%YoY in January after contacting/decelerating to -11%YoY and 2.7%YoY last month. The consumer goods imports also rose to 17.5%YoY (vs. +12.8%YoY in December).
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Dancing with the Bulls and the Bears
March 07, 2007
By Serhan Cevik | London
The global financial system is not melting down, but volatility still creates challenges. The depth and breadth of globalization have certainly changed the trajectory and interdependence of business cycles by synchronizing macro policies and enhancing productive capacities. However, such underlying improvements are not enough to prevent the accumulation of economic imbalances and financial excesses. Indeed, the unique overlap of the structural forces of globalization, financial innovation, monetary easing and the recycling of petrodollars has created a global liquidity super-cycle — lowering real interest rates, fuelling economic growth and inflating asset prices all around the world. And with higher risk appetite and cheaper financing, investors have moved even beyond the confines of traditional risky asset classes into truly exotic markets and instruments. Of course, in today’s interconnected markets driven by overcrowded trades, anything — a bad trading day in China, disappointing economic data in the US or just a comment by a former central bank governor — can turn into a trigger for the bursts of volatility and risk reduction across the board. And this is exactly what has happened in the past two weeks (or years, for that matter). The turbulence in the world’s financial markets may be signaling the end of a bullish era or just a healthy correction, but what we know for sure is that global imbalances will keep challenging the ‘conventional’ wisdom. Liquidity-driven capital flows have become a dominant factor behind the lira’s strength. For years, we have argued that Turkey’s macroeconomic normalization, thanks to fiscal consolidation and structural reforms, justifies the appreciation of the lira’s equilibrium value (as well as re-rating of asset prices in general). However, it would be an awful mistake to ignore the role of liquidity-driven capital flows in determining valuations in the short run. Especially with higher interest rates in the aftermath of last year’s volatility shock, carry trades — investing low-yielding currencies into high-yielding markets — have become a dominant factor in Turkey’s financial markets (see Carry-Trade Magnet, February 9, 2007). Foreign investors increased their holdings of equity and domestic debt from $15.1 billion in 2003 to $54.6 billion at the end of 2005 and $67.5 billion in January. This is even higher than the $59 billion recorded just before the 2006 market turbulence, and also highlights a divergence from the behavior of residents who have accumulated foreign currency-denominated instruments. The most interesting aspect is non-residents’ appetite for domestic government debt. According to the latest figures, foreign holdings of domestic fixed-income securities increased by 20.1 billion lira in the past six and a half months to 41.3 billion lira. Put differently, foreign investors now account for 35.8% of non-bank holdings of domestic government debt, up from 20.7% last June and 11.5% at the end of 2003. Carry trades are sensitive to risk appetite, but we must not ignore structural improvements. In a world in which even central banks — the most risk averse financial institutions — seek risky assets, it is not surprising to see the unprecedented accumulation of carry trades and the growing complexity of derivatives (see The Curse of Alpha, November 16, 2006). Although the pattern of risk-taking has curiously become a cyclical phenomenon with seasonal variations, volatility bursts could still make emerging economies vulnerable to the unwinding of leveraged positions. With a large current account deficit and significant exposure to liquidity-driven capital flows, Turkey looks like a prime candidate, or does it really? First, unlike before last year’s volatility shock, liquidity conditions in domestic money markets provide a reasonable shield against exogenous risk adjustments. Second, and more importantly, prudent policies and structural reforms have made the Turkish economy more resilient against financial turbulence and kept the longest stretch of non-inflationary output growth on track in the past five years. In our opinion, this is the most critical, but also underappreciated aspect of Turkey’s structural transformation. In other words, since even countries with large current account surpluses have also suffered from financial turbulence, the risk is not just a function of being a carry trade, but critically depends on macroeconomic discipline and institutional progress.
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