unnamed (2)The recent move by the European Central Bank (ECB) to loosen monetary policy, which included cutting the deposit interest rate to a landmark -0.1%, looks set to provide a welcome boost to both Turkey?s money markets and its broader economy.

While the ECB?s dramatic measures on June 5 were primarily aimed at maintaining a fragile recovery within the EU, the benefits are likely to extend beyond the bloc?s borders.

From its side, Turkey will be hoping that an expected uptick in demand from the continent over the coming months brings both short-term capital inflows and more substantial gains through increased production orders and investment, which could prove useful in helping rebalance its current account deficit.

The ECB?s decision to move interest rates into negative territory is unprecedented, marking the first time that a major reserve bank has taken such action. The bank also lowered its key benchmark rate from 0.25% to 0.15%.

Announcing the decision, ECB president Mario Draghi described it as part of the bank?s efforts to encourage banks to increase lending to the real economy. ?We decided on a combination of measures to provide additional monetary policy accommodation and to support lending to the real economy,? he said.

Positives for Turkey

The impact of the ECB?s shift on rates was felt in Turkey within hours of the announcement. The Turkish stock market gained strongly on the day?s trading, with the BIST 100, the index of the leading 100 listed shares, climbing 1.8%. The top 30 ? which are mainly industrials and banks ? edged upwards by just over 2%.

Commenting ahead of the bank?s decision, Erkan Dernek, market strategist at Odeabank, said that measures from the ECB would increase the appeal of Turkey?s portfolios. ?Recent expectations that the ECB may cut rates and the US Federal Reserve will remain dovish have made emerging markets more attractive, particularly Turkish assets because of the high interest rate,? he told Reuters.

The Turkish Central Bank?s key rate currently stands at 9.5%, having been cut by 0.5% at the end of May. The rate is seen by the bank?s governor, Erdem Ba???, as a necessary means of keeping local lending growth and inflation in check.

If the EU markets become more liquid, Turkey?s high rates could begin to attract greater capital inflows in the coming months, helping to negate the effects of any further fiscal tapering by the US Federal Reserve. Yields on government bonds and other instruments are far higher than those on offer elsewhere.

Higher domestic spending within the EU bloc should also produce a knock-on effect in Turkey?s manufacturing sector. The country is gearing up for an increase in orders from Europe in the third quarter, and rising demand for goods from the EU may well push up share prices in manufacturing firms, setting the scene for renewed investment.

Plugging the deficit

New orders and investment will not only spell good news for Turkey?s real economy, but could also help find an alternative to using short-term capital inflows as a means of bridging the current account deficit, which stood at $4.79bn in April, according to figures released by the government in June.

A recent World Bank report concluded that Turkey would benefit from making changes to some of its fiscal policies, including reducing its dependency on short-term capital flows. The report, issued in early June just before the ECB rate cuts, warned that the change in capital inflow patterns witnessed over the past five years could leave the Turkish economy and financial markets exposed during times of fiscal instability.

?While the bulk of the capital inflows were in the form of foreign direct investment in the mid-2000s, there has been a shift to short-term portfolio flows in the post-2009 crisis period. The heavy reliance of foreign inflows has given rise to significant volatility, with robust growth in periods of high inflows and slowing growth when capital flows out,? the report said.

It added that in recent years, portfolio and short-term capital inflows had dominated long-term capital flows, increasing the risk of capital reversals and leading to a worsening in the composition of investments.

Spending shift

In its recommendations, the World Bank urged Turkey?s government to broaden the country?s tax base and reduce its reliance on cyclically volatile consumption-based taxes. It also suggested shifting spending towards public investment and restraining growth in current spending. Such an approach would pave the way for a growth model less dependent on debt-financed consumption, the report concluded.

An expected flow-on from the ECB?s measures is unlikely to yield results in Turkey before the traditional summer slowdown. However, the country will be watching for a marked recovery in Europe, which could provide a welcome stimulus for real growth and pave the way for a rise in investment from the latter part of 2014 onwards.

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