Financial Stability Report

Transcription

1 Financial Stability Report November 212 Volume: 15

2 Head Office İstiklal Cad. 1 Ulus, 61 Ankara, Turkiye Tel: (9 312) 57 5 Fax: (9 312) Telex: 4433 mrbrt tr World Wide Web Home Page: bankacilik@cbrt.gov.tr, info@cbrt.gov.tr ISSN ISSN (Electronic) This report, aimed at informing the public, is based mainly on September 212 data. Nevertheless, the report includes developments and evaluations up to its date of publication in Turkish. The full version of this text is available on the CBRT website. The CBRT cannot be held accountable for any decisions taken based on the information and data provided therein.

3 FOREWORD Although uncertainties regarding the global financial system have tapered off, an environment of confidence and stability is yet to be established. While problems that surfaced with the global financial crisis differ by regions, they make their presence known by unveiling existing vulnerabilities. The recent monetary easing practices adopted by advanced economies have been fuelling concerns over financial stability by affecting capital flows to emerging economies. In this conjuncture, it is crucial to have a flexible policy framework and correctly analyze the potential risks to give the appropriate policy response on time. In Turkey, factors that may threaten financial stability are monitored very closely by various entities, in particular by the Financial Stability Committee; and necessary measures are taken in a timely manner. In this period, the Turkish banking sector remains resilient against external shocks thanks to its strong structure and the macroprudential measures implemented by the authorities. The Central Bank of the Republic of Turkey designed and put into practice by the end of 21 a new monetary policy strategy with the aim of mitigating the adverse impacts of uncertainties in the global economy on the Turkish economy and supporting financial stability. In this framework, as a consequence of measures taken in collaboration with other relevant authorities, credit growth came down to reasonable levels consistent with financial stability and the rebalancing process started. This new policy mix made a significant contribution especially in relation to curbing the unfavorable impact of excessive volatility of capital movements on domestic markets. In the upcoming period, the CBRT will continue to implement innovative policies to support macroeconomic stability. In the context of international developments, Turkey s contribution to global financial stability and also its effectiveness in the international arena will strengthen as the country takes over the Presidency of the G2 in 215; its representative power in the IMF increases as a consequence of the IMF Quota and Governance Reform and as Turkey chairs the Financial Stability Board (FSB) Regional Consultative Group for the Middle East and North Africa (MENA) in 213. I hope that the fifteenth volume of this Report which assesses Turkish financial system in the light of global and domestic developments will be of benefit to all readers. Erdem BAŞÇI Governor

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5 CONTENTS Contents Overview i iii I. International Developments 1 II. Domestic Economic Outlook 9 III. Risks and Developments in the Banking Sector 35 IV. Special Topics 61 IV.1. Reserve Option Mechanism in Reserve Requirements 61 IV.2. Interest Margin and Interest Rate Determinants in the Turkish Banking System 65 Financial Stability Report November 212 i

6 Financial Stability Report November 212 ii

7 OVERVIEW The uncertainties that swept through the world following the global financial crisis persisted in the second half of 212 as well, and global economic activity is yet to reach the desired level. Constraints over capacities of public finances especially of advanced economies to support growth and the resulting policy uncertainties are the two factors that have been hampering recovery. In the United States, problems regarding public finance pose a risk to global growth; while uncertainties over the economic outlook in the EU fuel the recession risk. Despite regional discrepancies, growth prospects for emerging economies that displayed strong growth performance during the preceding period are also revised downwards due to the adversities of advanced economies and the contagion effect. Recent fiscal measures introduced by the authorities towards resolving problems in the global economy are welcomed by the markets and this positive perception underpins the relative upward shift in the outlook of global financial markets. In this framework, the upside pressure on bond yields in the Euro area have been taken under control to some extent and the risk of deepening of financial problems in the region has been subdued for the current period. Meanwhile, the expansionary monetary policies implemented by advanced economies in order to revive their economic activities have led to a global liquidity surplus and limited the fall in stock markets and commodity prices. Such a liquidity surge also helped the risk appetite to continue its increasing trend and fuelled capital inflows to those emerging markets that have relatively better fiscal positions and growth prospects. Global uncertainty driven mainly by the advanced economies necessitates emerging economies to adopt more flexible and efficient policies. In this period, many emerging economies have made structural reforms and introduced unconventional policy implementations to manage macro financial risks. In Turkey, relevant authorities implement their policies in a coordinated manner on various platforms, the Financial Stability Committee being the leading one. Towards the end of 21, the Central Bank of Turkey broadened the scope of its inflation targeting strategy to encompass financial stability, and started implementing a new policy mix. Within this framework, the interest rate corridor, effective liquidity management and reserve requirements started to be employed as active policy tools. Thus, a new policy framework has been designed that does not overlook excessive volatility both in credit growth and real exchange rates for the sake of supporting macroeconomic and financial stability. This approach was quite instrumental in mitigating the adverse impacts of the volatile capital inflows on domestic markets for the last two years. Recently, a new policy instrument has been designed and introduced to restrict the adverse effects of excessive volatility in capital flows. This new policy instrument, called the Reserve Option Mechanism, has aimed to incentivize banks to voluntarily accumulate foreign exchange and use these reserves in a controlled and efficient manner when needed. This mechanism, which is anticipated to function as an automatic stabilizer against external financial shocks in the upcoming period, will soon be completed. Financial Stability Report November 212 iii

8 As a consequence of the new policy mix and contributions of other relevant authorities, domestic demand in Turkey was reined in and economic activity slowed down while the contribution of external demand to growth increased and, consequently, the growth composition assumed a healthier outlook. Thus, the current account balance gradually improved during the last year. Inflation, which rose due to the accumulated reflection of the rise in costs in 211, assumed a downward trend again once the temporary factors tapered off. Meanwhile, recently, a relative deterioration has been observed in the budget balance due to the slowdown in tax revenues coupled with the acceleration in non-interest expenditures. Nevertheless, the recent budget measures together with the low level of public borrowing requirement and costs support the positive outlook in public debt stock indicators. The recent improvement in the global risk perceptions and risk appetite towards the Turkish economy is likely to pose an appreciation pressure on exchange rates. Hence, the steady appreciation trend in domestic currency in real terms that has been observed since the beginning of the year should be closely monitored from a financial stability standpoint. Under the current floating exchange rate regime, there is no commitment regarding the level of the exchange rates; yet, in terms of macroeconomic and financial stability, it is important to take measures against excessive volatility, as necessary. The Central Bank of Turkey attributes special importance to credit developments under the new policy framework. From financial stability point of view, credit growth is at reasonable levels owing to the flexibility of the current monetary policy implemented and measures taken by relevant authorities. As the upper limits for FX and gold reserves that might be held to maintain Turkish lira reserve requirements were raised, banks Turkish lira liquidity needs have decreased and credit interest rates have assumed a path that underpins growth. The current path in interest rates is expected to continue in the upcoming period and credit growth is envisaged to hover around 14 percent at the end of the year. Given the weak outlook for global demand, keeping the rate of credit growth at moderate levels is especially important for ensuring that both the level and the composition of the aggregate demand move towards the desired direction. In this context, average annual credit growth rates below the 15 percent level would support both price stability and financial stability in the periods ahead. Banking indicators suggest that the overall structure of the sector is strong. In July 212, Basel II standards started to be implemented in Turkey; banks capital adequacy ratios remain high and the banking sector maintains its strong profitability. The scenario analysis, which tests the resilience of the banking sector against shocks originating from credit and market movements, shows that capital position of the sector has the capacity to absorb shocks. In this period, growth in firms indebtedness ratios decelerated and the share of their external borrowing assumed a steady path. The fact that the majority of credits borrowed from abroad were long-term and their sources varied both in terms of quality and regions contained the risks to corporate sector s indebtedness. The ratio of corporate debt to equity capital, which had increased in 211, decreased to some extent in this period. The ratio of firms net profit to equity capital has increased recently due to the rise in sales and decline in financial expenditures. Meanwhile, firms Financial Stability Report November 212 iv

9 continue to hold net FX short position and it is observed that foreign exchange exposure is still critical for firms. Accordingly, it is crucial to make the necessary regulations and continue to focus on measures that would on the one hand increase firms usage of equity capital, and on the other, encourage them to borrow from domestic markets in Turkish lira. The growth in household consumption and liabilities has slowed down on the back of the measures taken. The unemployment rate started to decline owing to measures taken to support employment and the rapid recovery in the aftermath of the crisis. However, the low level of household savings is still a concern for Turkey. Recent measures taken to raise household savings by encouraging private pension funds together with the strategic investment incentives introduced to improve the external balance are expected to support macroeconomic stability in the long run. Meanwhile, it is crucial to take other measures towards increasing savings in order to contribute to the financial stability further. Featured below is the financial stability map, which is prepared in the light of the abovementioned assessments and shows financial stability indicators in Turkey in a comprehensive manner. Financial Stability Map 1,2 Global Economy 1, Banking Sector,75 Global Markets,5 Household Sector,25 Domestic Economy, Corporate Sector Domestic Markets Public Sector Balance of Payments (1) The closer to the center, the more stable the sector is. Analysis allows time series comparisons within each sector. Among sectors, the comparison can be made in terms of the directional change in position with respect to the center. (2) For the methodology used in the financial stability map, see Special Topic IV. 1 in Financial Stability Report-13, dated November 211. As illustrated above, global economy exhibits more adverse developments while developments pertaining to global markets display a more favorable outlook compared to 211. This discrepancy indicates that problems in advanced economies linger and implemented measures have impact initially on markets via expectations while it takes time for them to impact the global economy as indicators are announced with a time lag. Financial Stability Report November 212 v

10 In Turkey, indicators pertaining to the economy in general and to the markets point to a more favorable outlook compared to 211. It is observed that this favorable outlook in the domestic economy and domestic markets is also valid for the developments of the banking sector and the balance of payments. Meanwhile, the slightly unfavorable outlook in households, corporate and the public sector compared to end-211 should be more closely monitored in the upcoming period. Financial Stability Report November 212 vi

11 I. INTERNATIONAL DEVELOPMENTS Uncertainties in global economic activity persist due to unfavorable growth indicators in advanced economies. Lingering concerns regarding the EU economy; and growth problems and fiscal constraints in the US and Japan fuel volatility in the markets. To tackle these problems, the authorities in the advanced economies are taking measures that are welcome by the markets while central banks are implementing expansionary monetary policies that cause a global liquidity surplus. Despite these measures and ample liquidity, the credit channel in advanced economies still fails to function as effectively as desired. Lingering uncertainties coupled with ample liquidity conditions do not only adversely affect growth and price stability in countries importing raw materials by pushing commodity prices up, but also pose a serious risk to financial stability in developing countries as they induce volatility in capital inflows. As these developments influence the growth momentum in developing countries, their growth projections have recently been revised downwards. In the aftermath of the global financial crisis, the recovery in economic activity in advanced economies remained below expectations and growth forecasts were generally revised downwards. Credit supply problems and fiscal policy that is unable to support growth have hindered recovery in economic activity in advanced economies. Even if central banks have attempted to underpin growth and employment by implementing expansionary monetary policies amid low inflationary pressure, ongoing structural problems and deleveraging operations in the finance sector are limiting the effectiveness of these policies. Actually, the decline in growth rates of advanced economies continues and international institutions have been revising their growth forecasts downwards for 212 and 213 (Chart I.1, Chart I.2). Chart I.1. Annual Growth Rates in Selected Countries (%) Source: IMF (*) Prediction * 213* Japan UK USA Euro Area Chart I.2. Growth Prospects for 212 (%) Source: IMF January 211 Projections April 212 Projections November 212 Projections USA Euro Area Germany France Spain Italy UK Employment rates in the US have not yet reached the desired level, and this has urged the Fed to introduce a third round of open-ended quantitative easing. The Fed announced that it would expand its holdings of long-term securities with open-ended purchases of USD 4 billion of mortgage backed securities a month in response to the still-high unemployment rates despite previous fiscal and monetary plans. It was stated that open-ended purchases would continue until employment rates improved significantly (Table I.1). Moreover, at the Fed s October meeting, various opinions were voiced about linking the Fed s expansionary policies to some specific Financial Stability Report November 212 1

12 quantitative criteria. Accordingly, it was stated that the easing of monetary policy would continue as long as necessary to bring down unemployment unless there was an inflationary pressure. Therefore, the exact amount of liquidity to be injected into the market is unknown. Neither the impact of this new policy on employment nor their prospective reverberations on the global economy are clear as yet (Chart I.3). Table I.1 Fed s Policy Decisions Chart I.3. Change in US Inflation, Unemployment and Fed Balance Sheet 1 (%) Starting Date End Date QE1 Dec-8 Mar-1 QE2 Nov-1 Jun-11 Operation Twist Sep-11 Dec-12 Explanation Purchasing billion USD Mortgage-Backed Securities (MBS) and 3 billion USD Treasury Bond Purchasing 75 billion USD Treasury Bonds monthly Purchase billion USD of bonds with maturities of 6 to 3 years and to sell bonds with maturities less than 3 years 4 billion USD a month, QE3 Sep-12 open-ended, bond Open-ended purchasing program of agency MBS Source: Fed Total Effect (Billion USD) Uncertain * 213* Inflation Unemployment Change in Monetary Base (Right Axis) 12 1 Source: IMF and Fed (1) Shows annual change in Fed Base Money. (*)Inflation and Unemployment are IMF forecasts; shows change in Fed base Money between October 212-December 211. Problems with public finances in the US continue to pose risk to global growth. The arrangement, which calls for automatic tax hikes and spending cuts, is likely to lead to a fiscal cliff that will adversely affect growth. Moreover, the debt limit has already been reached and the necessity to raise the limit again further fuels political risks (Chart I.4). In the worst-case scenario, rapid tax growth and drastic spending cuts can make a negative impact on the recently recovering US growth and employment performance (Chart I.5). Recent experiences of EU countries emphasize the importance of establishing budget discipline before market pressure and of opting for a gradual transition period instead of a tight austerity policy Chart I.4. US Debt Limit and Public Debt Subject to Limit (Trillion USD) Debt Limit Debt Subject to Limit Source: US Department of the Treasury and Office of Management and Budget, White House 1.12 Chart I.5. Possible Impact of Fiscal Cliff on 213 Global Growth (Deviation from the Baseline Scenario, %) USA Source: IMF -.4 World -.2 Latin America Emerging Asia Japan Euro Area (Core) Euro Area (Periphery) -.2 Remaining Countries Financial Stability Report November 212 2

13 Unresolved problems on public finances and austerity policies introduced to narrow the budget deficit have caused EU countries to slide deeper into recession. The risk of Greece s bankruptcy has not yet completely dissipated; and banking and public finances problems in peripheral Euro Area countries like Spain have reached a level that threatens the future of Euro (Chart I.6). While tight fiscal policies suppress domestic demand across the EU, these policies are adversely affecting growth and employment amid the already deficient external demand. Actually, growth prospects for the EU are constantly being revised downwards. Nevertheless, the measures taken are partly offsetting the upward pressure on bond yields (Chart I.7). Chart I.6. Primary Budget Balance in PIIGS Countries/ GDP (%) Greece Ireland Italy 3.9 Source: IMF Fiscal Monitor, Prediction -.7 Portugal Spain -.8 Chart I.7. Bond Yield Spreads between Selected EU Countries and Germany (basis points) Source: Bloomberg Ireland Italy Portugal France Spain Belgium The nexus between public finances problems and the banking sector in the EU have accelerated efforts to establish a single banking supervision and regulation mechanism. Under this new system, the supervision and restructuring of banks within the EU is planned to be shifted from governments to European level. Hence, ECB supervision will be phased-in to cover systemically important European banks first and then all other European banks. However, it is has been discussed that the effectiveness of this plan would be limited if it is put into practice without establishing a single resolution mechanism. Moreover, even if the European Commission has presented its plan, the boundaries of supervision and oversight between national authorities and the ECB are not yet clear. Resolving these problems in the fastest way possible would be an important step because cutting the ties between the EU banking system and local authorities and country risk exposure is expected to spur growth and promote the efficient functioning of the credit channel (Chart I.8, Chart I.9). Financial Stability Report November 212 3

14 Chart I.8. The Prospective Effects of Various Chart I.9 Prospective Downside Effects of Policy Scenarios on GDP (%) 1 Various Policy Scenarios on Credit Supply (Ratio to Total Loans, %) Core Euro Area - Weak Policies Core Euro Area - Complete Policies Periphery Euro Area - Weak Policies Periphery Euro Area - Complete Policies Complete Policies Baseline Policies Weak Policies Periphery Euro Area Core Euro Area Source: IMF Global Financial Stability Report, October 212. (1) Core Countries: Austria, Belgium, Finland, Germany, the Netherlands Peripheral Countries: Greece, Italy, Spain, Ireland, Portugal Source: IMF Global Financial Stability Report, October 212. Baseline Policies: Envisages that the banking union will proceed as planned, the pressure on the spreads within the framework of the OMT (Outright Monetary Transactions) of the ECB will decline and peripheral countries will follow through with their adjustment programs. Weak Policies: Envisages that the measures stated in the baseline scenario are not taken. Strong Policies: Envisages that Euro Area policymakers advance timetables for actions assumed in the baseline scenario and they present a clear roadmap to a banking union and fiscal integration and deliver a major down payment toward those goals. The additional capital requirement, which emerged as a result of the new regulations in the EU banking system, has been pushing EU banks to accelerate deleveraging and decrease their investments in risky countries. Therefore, in response to the additional capital requirement and increased funding costs, European banks have been decreasing their assets and squeezing the credit supply. European banks downsizing operations on their balance sheets and funding problems are limiting the credit supply to especially to Central and Eastern European countries and some Euro Area countries. Meanwhile, there are signs that the European financial system has a fragmented structure. According to this assumption, the more confidence in peripheral countries wanes, the clearer the discrepancies between core and peripheral European countries become. While international capital flows towards these countries are gradually decreasing; demand for other temporary ECB substitute instruments LTRO (Long-Term Refinancing Operation), the SMP (The Security Markets Program) and EU funds are increasing (Chart I.1) Growing fears of a Euro exit by the weakest Euro Area countries urge European banks to try to balance their assets and liabilities with these countries. Moreover, as a consequence of the decline in investments in these countries, credit conditions in peripheral European countries have become tighter (Chart I.11). Financial Stability Report November 212 4

15 Chart I.1. Total Liabilities of Eurozone Banks from PIIGS Countries (Billion euro) Banks SMP EFSF/EFSM ECB Chart I.11. Results of Bank Lending Surveys in the Euro area (Index) Source: IMF Global Financial Stability Report, October 212. Source: ECB (1) Positive values suggest stricter credit standards compared to the previous period. The ECB introduced some new policy measures to clear blockages in the credit channel and avoid further deepening of financial instability. In this framework, the ECB s announcement that it would implement the Outright Monetary Transactions program provided that member states accepted IMF and EU-backed macroeconomic policies and the long-term refinancing operations it carried out proved to be effective in the short run. However, the long-term effectiveness of these measures in remedying credit supply problems due to structural troubles in the finance sector is still being debated. While countries that are struggling with growth and public finances challenges are pushing the ECB to implement an expansionary monetary policy; countries led by Germany urge the ECB to implement policies that focus on price stability (Chart I.12, Chart I.13). Chart I.12. EURIBOR-OIS Spread (Basis Points) 12 Chart I.13. Banking Sector Loans in Euro Area (Billion euro, %) 11, ,25 11, 1, , ,25 1, 9, Loans Growth Rate (Right Axis) Source: Bloomberg Source: ECB While monetary expansion in advanced economies led to a surplus of global liquidity and stimulated recovery in asset prices on the one hand, it fuelled volatility in capital flows on the other. Ample liquidity following the crisis offset the loss in stock markets and commodity prices (Chart I.14). Nevertheless, deficient global demand limits the general inflationary pressure of commodity prices. Moreover, while liquidity and low returns cause increased international capital flows; high volatility is observed due to investors over-sensitive reactions to developments amid global uncertainties and lingering low growth performance (Chart I.15). All in all, ongoing Financial Stability Report November 212 5

16 problems in the banking sectors of advanced economies are restraining international capital movements. Chart I.14. MSCI Equity and Commodity Index ( =1) Chart I.15. VIX Index MSCI World Index S&P GS Commodity Index Source: Bloomberg Source: Bloomberg Growth in developing countries has been decelerating in parallel with global growth prospect. Many countries led by the BRIC countries are heading towards policies that support growth due to the economic slowdown (Chart I.16). The inflationary pressures in developing economies, which emerged as a consequence of the past years rapid growth performance, have muted recently owing to the ongoing risk of global recession (Chart I.17). Therefore, the macroprudential tightening measures started to be replaced by accommodative fiscal and monetary policies. Chart I.16. Annual Growth in Developing Countries (%) 1 1 Chart I.17. Inflation in Developing Countries (%) Source: IMF (*) Prediction * 213* Central and Eastern Europe Emerging Asia Latin America and the Caribbean Developing Countries 214* Source: IMF (*) Prediction * 213* Central and Eastern Europe Emerging Asia Latin America and the Caribbean Developing Countries 214* 2 Despite the slowdown in growth in developing countries, capital flows to these countries continue owing to their strong fiscal structures and growth potential. Although European banks carried out deleveraging operations in the face of the Euro crisis; developing countries saw no sudden drops in capital inflows as major central banks continued to implement expansionary monetary policies (Chart I.18). However, the discrepancy between developing countries became more remarkable after the Euro crisis. Central and Eastern European countries, which have close commercial and financial ties with the EU, have become the ones most severely affected by the Euro crisis; Latin American and Asian countries have been less affected. Capital flows were mostly Financial Stability Report November 212 6

17 composed of investments in debt securities, since investors thought that these countries were safe heaven compared to the risk of advanced economies, as well (Chart I.19). Chart I.18. Capital Flows to Developing Countries 1 (Billion USD) Equity Government Bond (Right Axis) Source: EPFR (1) Data derived from the sum of previous quarters. Chart I.19. Receivables of Banks Reporting to BIS from BRIC Countries (Billion USD) Source: BIS To sum up, the global integration, growth and development process in the pre-crisis period was replaced by regional discrepancies, vulnerabilities and contagion effects as the global financial crisis loomed. In this period, the restructuring process and new regulations both at national and international level, as well as trade protectionism are coming to the top of the agenda on the one hand, more weight is given to international coordination and cooperation on the other. However, ultimately, recovery is closely related to the policies a country implements and its political will. Currently, advanced economies are undergoing a balance sheet deleveraging process while rapid credit growth is curtailing vulnerabilities in developing countries thanks to their growth potential and relatively strong public finance structure. Meanwhile, the European financial system is displaying a fragmented structure. Due to the problems in EU countries, the USA and Japan are taking extra credit for being risk-free countries and financing costs are decreasing in these countries. Nevertheless, fiscal cliff and debt ceiling issues are still at the top of the US and thus global agenda. All in all, despite some recovery signals in the international financial system, confidence has not yet been restored. In this period, it is crucial to implement financial system reforms at the right time and in the right order; and support them with effective and innovative policies Financial Stability Report November 212 7

18 Financial Stability Report November 212 8

19 II. DOMESTIC ECONOMIC OUTLOOK In the first nine months of 212, the slowdown in economic activity continued and the growth composition showed that demand components were rebalancing. The current account deficit narrowed on the back of net exports significant contribution to growth. A relative decline in budget performance is observed that can be attributed to the decrease in growth rate of tax revenues driven by the deceleration in economic activity and acceleration in primary expenditures. Growth rate in household liabilities has slowed down owing to measures taken by the authorities; and the rise in corporate indebtedness observed in halted. Although inflation in the third quarter of 212 remained above expectations due to energy prices, unprocessed food products prices and public price adjustments; core inflation indicators and moderate growth suggest that inflation will assume a downward trend in the upcoming period. Since mid- 212, the monetary policy became more accommodative in response to the partial improvement in the global risk appetite, the stronger rebalancing process in economy on the back of the policies implemented; and the stronger contribution of domestic demand to disinflation. The reserve option mechanism enhanced the resilience of the banking sector against external financial shocks. The above mentioned mechanism and the rise in export rediscount credits have supported the foreign exchange reserves. With the positive effect of the CBRT S accommodative policies coupled with the partial improvement in the global risk appetite, domestic market rates decreased and loan rates are gradually decreasing in tandem with the former. It is expected that both demand and supply factors will assume a trend that will support credit volume starting from the final quarter of the year and growth is expected to pick up owing to the moderate recovery in consumption demand. In the upcoming period, the CBRT will continue to take all necessary measures for the sake of financial stability besides its primary objective of price stability. In the first half of 212, the slowdown in economic activity continued while the growth composition assumed a healthier outlook. GDP grew by 3.3 percent year on year in the first quarter of 212 and by 2.9 percent in the second quarter. Thus, the GDP, which increased by 8.5 percent in 211, rose by 4.9 percent in annual terms in the first half of 212. It can be observed that the economic activity slowed down after the first quarter of 211. The sounder structure of the growth composition proves that measures taken by the CBRT as well as other relevant institutions and the policies adopted have been mostly successful. As a matter of fact, final domestic demand started to decelerate starting from the second half of 211; growth was mainly driven by the net exports starting from the final quarter of 211 and thus, the rebalancing process in the demand composition continued. When contributions to annual growth as of the second quarter of 212 are analyzed, it is observed that while net external demand was the only factor that made a positive contribution; final domestic demand and stocks made a negative contribution (Chart II.1). While the weak growth in Turkey s main trade partner -the Euro area- curbs Turkey s external demand; exports to Africa and Middle East countries, the shares of which are constantly increasing in Turkey s exports, were favorable starting from the second half of 211 and imports started to decline due to the slowdown in domestic demand (Chart II.2). The impact of net exports of gold should not be overlooked in analyzing the significant contribution of net exports to annual growth; this contribution is believed to have stemmed from a seasonal increase in the external demand for gold. Financial Stability Report November 212 9

20 Chart II.1. GDP and Its Components (%, Annual Contribution) Chart II.2. Imports and Exports of Goods and Services (Billion TL) Source: TURKSTAT Final Domestic Demand Net Exports Stocks GDP 9, 8,5 8, 7,5 7, 6,5 6, 5,5 5, Exports Imports Source: TURKSTAT, CBRT (1) Seasonally adjusted national accounts at 1998 constant prices have been used. Although data pertaining to the third quarter of 212 suggest that the slowdown in economic activity continues, leading indicators point to a moderate recovery in consumption demand in the final quarter of the 212. Using seasonally adjusted data the quarterly average capacity utilization ratio remained below the level of the previous quarter and the quarterly average of the industrial production index displayed a limited rise (Chart II.3). On the other hand, recent leading indicators suggest that economic activity will pick up in the final quarter. As a matter of fact, the leading indicators index, the Turkish Exporters Assembly Index (TIM) and the 3- month ahead expectations for domestic and export orders all point to a slight recovery (Chart II.4). In the Medium Term Program (MTP) announced in October, it was stated that the growth rate for 212 would be 3.2 percent based on forecasts that the contribution of net exports of goods and services will decline and domestic demand will relatively recover. Chart II.3. Industrial Production and Capacity Utilization (25=1, Quarterly Average) Industrial Production Index Capacity Utilization Rate (%) Chart II.4. 3-Month Ahead Expectations for Orders (%) Month Ahead Expectations for Export Orders 3-Month Ahead Expectations for Domestic Market Orders, TURKSTAT (1) Seasonally adjusted data. (1) Seasonally adjusted data. The foreign trade balance and current account balance continue to improve. As a result of the continued rise in exports and decline in imports in the third quarter, the annual foreign trade deficit, which was USD 85.2 billion in March 212, came down to 7.1 billion in September 212. The ratio of imports covered by exports was up from 63.4 percent in March 212 to 69.3 percent in September 212 (Chart II.5). In tandem with the improvement in the foreign trade Financial Stability Report November 212 1

21 balance, the annual current account deficit, which was 71.8 billion in March 212, decreased to 55.8 percent in September 212. Meanwhile, the recovery in the current account deficit excluding gold was more limited. The said item, which was USD 68.4 billion in March 212, became 59.5 percent in September 212. In the same period, the current account deficit excluding energy became USD 4 billion (Chart II.6). In the MTP, it is projected that the ratio of current account deficit to GDP, which was 1 percent in 211, will be 7.3 percent by the end of 212. Chart II.5. Foreign Trade Balance (Annual) Chart II.6. Current Account Balance (Annual, Billion USD) Foreign Trade Balance (Billion USD) Current Account Balance Current Account Balance (excl. energy) 9.12 Exports / Imports (%) (R.-hand axis) Current Account Balance (excl. gold), TURKSTAT While the share of long-term borrowing in the financing of the current account deficit is higher compared to that of crisis period, recently the share of short-term borrowing has slightly increased. Annual net capital inflows, which accounted for 6.9 percent of the GDP at the end of 211, became 6.9 percent by June 212 again, displaying no change (Chart II.7). While the shares of direct investments and long-term capital inflows significantly increased in 212 compared to end-21, in the first nine months of 212 the share of short-term borrowing displayed a slight rise compared to end-211, mainly stemming from the decline in long-term borrowing of banks and other sectors, and the increase in banks short-term deposits. Chart II.7. Financing Structure of the Current Account Deficit Amount of Capital Inflows (Annual, Billion USD) 1 Capital Inflows (Annual, % GDP) Direct and Long Term Investments Portfolio and Short Term Investments Direct and Long Term Investments Portfolio and Short Term Investments Capital Inflows Capital Inflows (1) Portfolio and short-term capital flows is composed of equities, domestic debt securities of the Government and banks, short-term loans of banks and other sectors and deposits at banks. Long-term capital flows is composed of long-term net loans of banks and other sectors and bonds issued abroad by banks and the Treasury. Financial Stability Report November

22 Risk premia of developing countries decreased on the back of the rise in the global risk appetite; meanwhile in Turkey, real effective exchange rates started to appreciate and exchange rate volatility remained limited. As many developing countries implemented expansionary monetary policies in the third quarter of the year, the global risk appetite has been increasing since June and capital flows to developing countries have again been revived. In this period, Turkey s risk premium followed a trend parallel to those of other developing countries. The rise in the global risk appetite, better-than expected macroeconomic indicators particularly current account deficit data- and the global credit rating agency Fitch s upgrading of Turkey s long-term credit rating in November 1 stimulated a rise in real exchange rates (REER) (Chart II.8). In the third quarter of the year, exchange rate volatility displayed a downward trend on the back of the decline in developing countries risk premia. The implied volatility of the Turkish lira remained lower compared to other developing countries owing to the favorable trend in its macroeconomic indicators and the policies implemented by the CBRT (Chart II.9). Although the CBRT has no commitment to the level of exchange rates, it will not turn a blind eye to excessive volatility in order to ensure macroeconomic and financial stability. Chart II.8. Real Effective Exchange Rates (Based on CPI, 23=1) CPI Based Real Effective Exchange Rate (23=1) CPI Developing Countries Based Real Effective Exchange Rate (23=1) CPI Developed Countries Based Real Effective Exchange Rate (23=1) Chart II.9. Implied Volatility of Exchange Rates (%, 12-month) Developing Countries Turkey Source: Bloomberg, CBRT (1) Emerging economies include Brazil, Chile, Czech Republic, Hungary, Mexico, Poland, South Africa, Indonesia, South Korea and Colombia. Budget performance has relatively weakened due to the decline in growth of tax revenues amid the slowdown in economic activity and acceleration in primary expenditures. Compared to 211, budget performance slightly deteriorated in the first three quarters of 212 due to the significant slowdown in tax revenues in tandem with the rebalancing process in economic activity; the rise in primary expenditures mainly stemming from the acceleration in the personnel expenditures and current transfers; and lastly the unfavorable base effect of the decline in tax revenues collected as per the Law on the Restructuring of Public Receivables. Consequently, the annual central government primary budget surplus, which was TL 24.4 billion at the end of 211, decreased to TL 13.2 billion in October 212 (Chart II.1). Meanwhile, the central government budget deficit increased from TL 17.8 billion at end-211 to TL 34.8 billion in October 1 The global credit rating agency Fitch upgraded Turkey's Long-term Foreign Currency Issuer Default Rating (IDR) to 'BBB-' from 'BB+' and the Long-term Local Currency IDR to 'BBB' from 'BB+, thus upgrading Turkey's credit rating to investment grade. Financial Stability Report November

23 212 (Chart II.11). The budget deficit, which accounted for 1.4 percent of GDP at the end of 211, reached 2 percent of GDP by June 212. Hikes to SCT rates on motor vehicles and the lump-sum taxes on fuel and alcoholic beverages as well as title fees under the fiscal measures enforced in September in order to raise revenues are expected to bolster budget revenues in the last quarter of the year. Therefore, central government budget revenues, which was initially projected to be TL billion, is projected to be TL billion in the MTP. Chart II.1. Primary Budget Balance Chart II.11. Budget Balance , 4,5 4, 3,5 3, 2,5 2, 1,5 1,,5, Primary Budget Balance (Annual, Billion TL) Primary Budget Balance / GDP (%) (R. -hand axis) Budget Balance (Annual, Billion TL) Budget Balance / GDP (%) (R. -hand axis) Source: Ministry of Finance, TURKSTAT Source: Ministry of Finance, TURKSTAT The favorable trend in public debt stock indicators continues. Central government debt stock, which reached TL billion by the end of 211 with a 9.5 percent rise compared to 21, became TL billion in October 212. The ratio of debt stock to GDP decreased from 39.9 percent in 211 to 38.2 percent in June 212 (Chart II.12). By October 212, 72.9 percent of central government debt stock was composed of domestic debts. An analysis of the composition of domestic debt reveals that in 211 and 212 till October, the share of TL denominated fixed-rate debt and CPIindexed debt increased compared to 21 (Chart II.13). Meanwhile, the maturity of domestic debt stock has been extending; the maturity, which was 31.1 months at the end of 211, became 32.4 percent by October 212 (Chart II.13). The share of FX denominated and FX-indexed stock in central government debt stock became zero in February 212 and this is quite a favorable development as the sensitivity to exchange rate risk is eliminated. Moreover, the rise in the share of fixed income securities and the extension of maturities reduces sensitivity to interest rate movements. The Undersecretariat of Treasury issued JBIC-guaranteed Treasury bills at the amount of JPY 18 billion with a maturity of 1 years and coupon rate of 1.87 in 211 and the same type of bills at the amount of JPY 9 billion with a maturity of 1 years and coupon rate of 1.47 in 212. Moreover, for the first time in its history, the Undersecretariat of Treasury issued rental certificates on 17th September and 3rd October; the issue on 17th September was carried out abroad denominated in USD, in the amount of USD 1.5 billion with a maturity of 5.5 years and the issue on 3rd October was carried out in Turkey denominated in Turkish lira, in the amount of USD 1.6 billion with a maturity of 2 years. Both rental certificate issues drew significant demand and the rate of return of both issues was at reasonable levels. The issues are considered favorable with respect to increasing domestic savings, expanding the investor base and proliferating financing instruments. Financial Stability Report November

24 Chart II.12. Central Government Debt Stock Chart II.13. Composition of Domestic Debt Stock (%) Billion TL % GDP (R. -hand axis) FX / FX Indexed CPI Indexed TL Variable Rate TL Fixed Rate Maturity (Month) (R. -hand axis) 15 Source: Undersecretariat of Treasury, TURKSTAT Source: Undersecretariat of Treasury Borrowing costs of the public sector remains low and the MTP envisages a tightening in public finance in the upcoming period. The cost of domestic borrowing, which has shown a downward trend since the beginning of 29, slightly increased in 211, but started to decline again later on. The interest rate, which was 7.5 percent in October 212, becomes.8 percent when adjusted for 12-month inflation expectations (Chart II.14). The framework for public finances presented in the MTP foresees that compared to 211, budget performance will slightly deteriorate in 212 due to the slowdown in economic activity but pick up again in subsequent years. According to the MTP, primary expenditures, which are projected to increase in 212 and 213 compared to 211, will gradually decrease starting from 214. Moreover, it is planned to boost budget revenues starting from 213 by introducing legal and administrative arrangements regarding tax increments and ensure the continued decline in the ratio of public debt stock to GDP by increasing the primary surplus (Table II.1). Chart II.14. Average Cost of Domestic Table II.1. Main Indicators Related To Public Borrowing (%) 1 Finance (Ratio to GDP, %) Nominal Source: Undersecretariat of Treasury, CBRT (1) Includes fixed income borrowing. Real 212* 213** 214** 215** Central Gov. Budget Balance -2,3-2,2-2 -1,8 Central Gov. Budget Revenues 22,9 23,6 23,1 22,6 Central Gov. Tax Revenues 19,4 2,2 19,9 19,6 Central Gov. Budget Expenditures 25,3 25,7 25,1 24,4 Primary Expenditures 21,9 22,3 21,9 21,4 Total Public Primary Balance (Program-Defined) 1,8 2 2,2 2,2 Central Gov.Budget Balance (Program-Defined),2,5,6,7 Central Gov. Revenues (Program-Defined) 22 22,8 22,5 22,1 Central Gov. Expenditures (Program-Defined) 21,9 22,3 21,9 21,4 EU Defined Nominal Debt Stock 36, Source: Medium Term Program ( ) * Forecast ** Target Although inflation saw single-digit levels in May 212, it has trended above the target and the downward trend only became remarkable as of the final quarter. Annual CPI inflation, which climbed to 11.1 percent in April 212, assumed a downward course as of May to be followed by a flat trend afterwards. Even if inflation trended above forecasts due to recent hikes in oil and unprocessed food prices as well as public price adjustments, the disinflation trend became clearer Financial Stability Report November

25 in the fourth quarter and CPI inflation became 7.8 percent in October 212 (Chart II.15). The downward trend in annual inflation of core goods continued on the back of the gradual decline of the cumulative impact of last year s movements in exchange rates and imports prices coupled with the slowdown in economic activity. The moderate trend in services prices persists. Even if the disinflation process is expected to continue in the upcoming period, a cautious stance in pricing behavior will be very important as inflation will still hover above the target due to the increments in administered/directed prices and energy prices. Meanwhile, core inflation indicators calculated by H and I indices moved in tandem with annual core goods inflation and became 6.8 percent and 6.1 percent in October, respectively (Chart II.15). Despite price adjustments in administered/directed prices, inflation expectations are still flat. Inflation expectations over the next 12 and 24 months became 6.64 and 6.13 percent by end-november and it is noteworthy that expectations are converging to the medium-term target of 5 percent (Chart II.16). Chart II.15. Inflation (Annual, %) 1 Chart II and 24 Month-Ahead CPI Expectations (%) CPI H Index I Index 12 Month 24 Month Source: TURKSTAT (1) SCA-H is CPI excluding energy, unprocessed food, alcoholic beverages, tobacco and gold. SCA-I further excludes processed food from SCA-H. As of mid-212, the monetary policy gradually became more accommodative in response to the partial recovery in global risk perceptions, the stronger contribution of domestic demand to disinflation and the rebalancing process in the economy. With the new policy mix that it put into practice as of end-21, the CBRT introduced some additional instruments to support financial stability. From the final quarter of 211 till mid-212, monetary tightening operations have been held in response to fluctuations in risk appetite and risks to the inflation outlook. Recently, the global risk appetite has to some extent assumed a recovery trend, credit growth and the current account balance have been favorable; rebalancing in economy has become stronger and the contribution of domestic demand to disinflation has become more remarkable. As a consequence of these developments, the CBRT has been increasing the amount of liquidity that it injects into the market since June to gradually decrease the average funding cost. In November 212, the CBRT weighted average funding cost dropped below the policy rate of 5.75 (Chart II.17). Moreover, taking into account the fact that the tail risks pertaining to the global financial system waned by September and in order to support the credit market, the CBRT gradually lowered the upper limit of the interest rate corridor. In September 212, the Monetary Policy Committee lowered the Financial Stability Report November