Monday, July 13, 2009

Weekly Hurriyet Column: A crazy little thing called liquidity

Below is the unedited version of my column for this week. You can read the final version at Hurriyet's authors archive. As for the liquidity squeeze, the two graphs below speak for themselves:

You can clearly see the mechanism I described in the third paragraph in these two charts. As for the margins versus averages argument, again, a picture would be worth more than a thousand words, but Blogger's upload picture is not responding:) Anyway, I had this really nice chart which showed that deposits had stalled in the past few months (despite the recent rise) while Central Bank funding was becoming more and more important.

Even though we have had our differences from time to time, I have to render unto the Central Bank (CBT) due credit for effective communication.

While markets were getting prepared for one last 0.25 percent points cut this month, expectations were deftly managed in a couple of days so that now almost everyone concurs that at least two more cuts are in the pipeline, with the base scenario being a 0.50 percent cut next week followed by a 0.25 percent final cut in August, after when the Bank would go on to hibernation for a considerable time. But the talk of town has been the technical rate cut.

To understand this issue, you need just two pieces of data and some basic knowledge of Central Bank accounting: The Central Bank has been losing reserves for almost a year, so cannot create money through foreign exchange operations anymore. As a result, liquidity shortage has turned sticky, and the CBT has been increasingly providing funding to banks since early in the year.

The Bank actually saw this coming, and outlined two policy actions to remedy this liquidity squeeze in the Liquidity Management section of its Monetary and Exchange Rate Policy for 2009 document, which was published mid-December.

First, it would implement a technical rate cut, whereby the repo rate, which drifts around the borrowing rate, would become the benchmark rate, with the new borrowing rate set 1.25 percent below. Second, to ensure that funding the liquidity shortage only with short-term repos would not have any adverse affects on long-term rates and the credit mechanism, it would hold repo auctions with maturities up to 91 days and purchase government securities, or reduce lira required reserve ratios is these don’t work.

In this sense, the extension of repo maturities after last month’s MPC meeting was a first step of these policy actions towards easing liquidity. While I do not want to speculate on the nature and timing of the Bank’s next move, all of these are, in essence, the CBT’s offer of a life buoy to banks to help them carry on Treasuries, as debt rollover is projected to remain high and capital flows weak.

Of margins and ghosts

As for the technical rate cut, it is likely to lead to lower rates as interbank lending would get more attractive than parking excess liquidity at the CBT. However, it has been argued that its effect will be marginal since deposits are the banks’ main funding sources, and their rates are rather high. While it is true that the average funding costs of banks experiencing lira shortage will fall only marginally, it is the marginal costs that will make the difference, as lira deposits have stalled recently. In short, the technical cut would lead to more bond demand and interbank lending as well as lower market rates. And if we are lucky, there may even be some leftovers for corporate credit.

IMF money fits in this context in the sense that it would decrease rollover ratios and ease up liquidity. So far so good, but one of the great ideas of Economics is that there is no free lunch. Without a credible fiscal framework, with or without the IMF, there is a serious risk that all of this could be perceived as fiscal accommodation, or even worse, debt monetization. These ghosts of Christmases past practically ruined the country in the last two decades of the last millennium, so even the thought gives me the shivers.

The CBT’s continuous pleas for a sound fiscal framework, which continue to fall on deaf ears, take an entirely new meaning when looked through this lens. I guess they are well aware that they are about to enter very dangerous waters with unconventional monetary policy, and the government is not really making it easy for them.

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