In the first three quarters of  4  BIS Review 20/2008  2007, the Gross National Product (GNP) increased by merely 4 percent, remaining at a level lower than previous years. Sorting out the underlying dynamics of growth developments is critical in shaping monetary policy decisions. It should be emphasized that while the limited GDP growth compared to previous years can be attributed essentially to the impact of monetary tightening; the marked contraction in the agricultural sector also had a significant influence, especially on the reduced growth rate in the third quarter. In other words, the slowdown in growth resulted partially from the supply shock. As I have emphasized at the beginning of my speech, the contraction in the agricultural sector did not only affect the growth unfavorably, but it also pushed inflation up for a temporary period in 2007. Figure 6: Private Final Consumption (Real, quarterly, seasonally adjusted)  Monetary Tightening  26000 25000 24000 23000 22000  2007-III  2007-II  2007-I  2006-IV  2006-III  2006-II  2005-IV  2005-III  2005-II  2005-I  20000  2006-I  21000  Source: TURKSTAT, CBRT. Figure 7: Contributions to Annual GDP Growth (Percentage Points)  20  Final Domestic Demand Net Exports  15  GDP  10 5 0  2007-III  2007-II  2007-I  2006-IV  2006-III  2006-II  2006-I  2005-IV  2005-III  2005-II  2005-I  -5  Source: TURKSTAT, CBRT.
For another, the sharp increase in loan volumes – especially for mortgages – against a backdrop of persistent economic uncertainty and the substantial rise in real estate prices points to higher credit risk. In addition, for first mortgages on residential properties, banks are required to have less capital backing under Basel II than they did under Basel I – before 2007 (i.e. under Basel I), a mortgage had to be backed with 4.0% capital; since then (i.e. under Basel II), that figure is only 2.8%. This not only gives banks an incentive to grant more mortgages, but also enables them to reduce the capital buffer used to absorb loan losses. In view of the increased interest rate and credit risk, we urge the domestically focused banks to be prudent. They must be prepared for interest rates to rise. Besides the direct effect on the interest rate margin, particular attention also needs to be given to the indirect effect of an interest rate increase, namely that if loans are granted without sufficient attention being paid to borrowers’ financial situations, a rise in the interest rate will inevitably result in higher loan losses. As I have mentioned, the domestically focused banks are well capitalised by historical standards. But in view of the risks and uncertainty, they will also need to maintain a large capital buffer.