Addendum to Hurriyet column, You don’t mess with the CBT

As promised, here's my addendum to this week's Hurriyet column.

But before I get into details, I should note that I am aware of an important weakness in my columns: When I am writing about a specific Turkish policy, I have to assume that the readers already know what the topic in question is. That's not because I am lazy, but simply because I have a 3700-character limit, which translates into 650 words or just one page... So I had to talk about the CBT's change to its FX auction scheme without actually explaining what the new process was like. But that's why I have the blog and this addendum, and I will quote my friends at GlobalSource / Turkey Data Monitor, who do a great job in summarizing the new procedures:

According to the scheme, the Bank will announce the maximum amount of additional F/X purchases it plans to make for the week, which will be spread unevenly throughout the week. The amount will be in addition to the regular daily purchases, which presently run around $40 million, but the optional amount (another $40 million) will not be exercised on the day of the additional purchase. The Bank has announced that it will buy a maximum of $300 million this coming week, which adds up to a maximum purchase of $500 million, including the regular purchases. The Bank will decide on the purchase amount on the day of the intervention, which could, in theory, vary between 0 and the maximum permissible amount. When there is no purchase that day through the new scheme, optional purchase will be reinstated. Further, as we understand it, the maximum weekly purchase amount could differ each week, if need be, depending on market conditions.

Now, according to the Central Bank, they are doing this to build reserves, but according to a recent paper from the IMF, building reserves is only useful if you don't have much to start with (see the second graph in that post). While Turkey's low reserve coverage could lead one to argue that it is below the magical threshold, I am not sure holding huge reserves would make sense for the Bank.

In fact, the Bank is plainly worried about the exchange rate. While I noted in my column that I don't see the change in the auction methodology as a sign that the CBT is entering the currency warfare, my editor at Hurriyet Daily News & Economic Review apparently does not agree with me. But some news from the trenches are definitely in order: The EU, Japan, China. Even think tanks, academics, international institutions and even the French have joined in the debate, so maybe Taylan is right; Turkey is in the Great War, we just don't know it yet.

But it is also useful to backtrack a bit and think about what brought us to this stage: As I briefly noted in the column, I believe the main reason is QEII and the associated strong flows to EMs. I am backtracking because it is useful to note an added benefit of this liquidity flush before coming to lira and reserves implications of this global environment. 

For one thing, The CBT has seen seen less need for temporary liquidity injections. This can be clearly seen by looking at the contribution of net domestic and foreign assets to base money growth, which is one of the key equations of the Turkish Econ. 101. I recently noticed that my friend and former boss at Citi has gone through this exercise; given that I am late for my jog, I will use his- this will also give you a glimpse of my desktop, although I doubt you will see anything too exciting:

Anyway, coming back to the lira and the reserves, there are some sound reasons that the impact (see Esther, I am not using it as a verb) of the new scheme on both will not be as strong as imagined, at least initially.

Let's start with the reserves, as it is easier. Another CBT action announced around the same time as the auction change was the decision to substantially cut (almost eliminate) interest rates the Bank pays to foreign currency deposit accounts of Turkish residents abroad. Those deposits are around $12 billion, but should converge to zero soon, as the Bank is now paying almost zilch on them... So the Bank's reserve accumulation will be set back initially.

As for the lira, with EFPR data pointing at very strong EM flows (that's the main support behind the lira's recent performance, which was interpreted by the ingenious Turkish media as the CBT policy not working). As long as that continues, there is limited scope for any Central Bank, not just the Turkish one, to significantly control currency appreciation. Besides, where the 12 billion mentioned above finds a home will matter for the direction of the lira in the short-run: I do not think it is given that they would find their way to Turkish banks as FX deposits; the interest differential might lead them to lira deposits, in which case, there would be further appreciation pressure on the lira.

On the other hand, one difference between Turkey and many other EMs is that from a theoretical point of view, there is not much of a case for further lira strengthening. We are talking about a current account deficit on its way to $40 billion. Moreover, as I argued in the previous week's column, the financing picture does not look comforting at all, at least in terms of the quality of the flows.

So this past couple of days is not a good timeframe to judge and dismiss CBT's new auction policy. I think it is a smart move and will actually work in the medium run by bringing some uncertainty to short-term flows and adding spice to FX trading...