Monday, November 15, 2010

Weekly Hurriyet Column: Capital punishment on the banks

Below is the unedited version of my column for this week. You can read the final version at the Daily News website, but since I have been editing my columns myself on the Daily News media webeditor since March, you won't see much of a difference between the two. And no cheesy movie references this time around: The title is just a wordplay: I wanted to emphasize that the MPC meeting and the reserve hike are response to capital flows, but the banks see it as capital punishment...

Jumping right into more serious matters, as is the norm, I do have an addendum, but before that let  me mention that I already posted on this topic on Friday: The editors at the Daily News had asked for my comments for an article they were doing on the same topic, and I decided to turn those comments into a post, but I had to write very quickly, so the post is somewhat disorganized and with a couple of grammatical errors. And while some of the stuff has found its way to the column, there is some extra material as well, so fell free to enjoy it as comp. reading. Speaking of comp. reading, the Daily News article is excellent comp. reading as well: I would suggest you actually read it first, especially if you don't follow the Turkish economy closely. Because of the space requirement of in the hard-copy edition of the paper, I never get to explain as much as I would like, leading sometimes to frustrated readers. But that's what this blog is for. 

Speaking of readers, a loyal reader asked me to explain the following statement on Friday's post: "...according to my calculations, the NAIRU is higher than before the crisis, and there is actually not that much slack on the employment front, either.":
please elaborate/quantify, just curious...i'm not on top of the numbers but the latest unemployment data was weak (unemp and nonfarm unemployment both increased). Industrial production slowed down in Sept. Eurozone losing momentum. Ok I can see a higher govt spending going into the elections but the numbers just don't add up. Thx.
The reader is right that Turkish growth numbers have started to slow down of late, since I claimed  at the end of last month that they were stronger that the CBT would have liked us to believe. I refined that point later on, saying on Friday's post that the CBT was concentrating on the weakest links of growth leading indicators by mentioning capacity utilization and unemployment in the MPC statement. My point was that the NAIRU might have increased because of the crisis: Actually, according to my calculations I had reported earlier, the seasonally-adjusted NAIRU is now at around 11 percent- before the crisis, it was at around 10 percent. I did not spend a lot of time with this exercise and have not updated it, but if NAIRU has indeed gone up, then overheating pressures could be building sooner than expected. And here's the latest unemployment figures, to put this discussion into perspective:
It is true that Friday's latest labor statistics brought seasonally adjusted unemployment to 12 percent as of August (actually average of July-September), but still, if I am right, there is about  only 1 percent of slack on the employment front. But nevertheless, the reader is right that industrial production slowed down in September. Moreover, Eurozone problems mean Turkish exports may suffer, leading to a bigger-than-expected negative contribution to growth from the external demand side. So things are moving in the Central Bank's favor, but all I'm saying is that there might not be as much slack in the economy as most analysts are suggesting. 

Now, to the actual addendum. Loyal readers would know how much I have adopted the phrase "a picture is worth more than a thousand words", so here's a picture showing the worsening of the financing of the current account deficit:
And another one that shows that the Central Bank is a net liquidity provider, as I claim in the column:
As you can see in the picture, the Central Bank was a net liquidity mopper until early 2008. Since then, it has turned into a liquidity provider. But the net figure hides the fact that banks awash with cash still lend to the Bank, as I had argued way back in April; this is what the Bank would like to change by decreasing its overnight borrowing rate to 1.75 percent. When you think about it, it is not efficient at all if liquidity-strained banks borrow from the CBT and cash-rich ones lend to it. That tells us the interbank market is not functioning properly and that's what the CBT would like to change. And if all had gone as planned, meaning no QE2 and the accompanying capital flows, the Bank was planning a system similar to the federal funds rate, whereby the policy rate would be equal to, and eventually be, the money market rate. By saying that the money market rate will be allowed to diverge from the policy rate, the Bank seems to have postponed that step a bit.

Anyway, now that I am done with my weekly chattering, on to the column:

Holidays should be a time for reflection and reconciliation. It should be no different for the Turkish banking sector.

Banks sharply criticized the Central Bank of Turkey’s, or CBT’s, decision on Friday to hike the lira required reserve ratio 0.5 percent to 6 percent. The CBT expects an impact of about 2.1 billion liras on liquidity when the new ratio will be in effect Nov. 26.

Since the main mandate of central banks is price stability, it is normal for the CBT, or any central bank for that matter, to wish to curb excessive loan growth, which could lead to overheating and inflationary pressures, by hiking reserve requirements.

While I can identify with the banks for shortsightedly worrying about their profits, I am surprised that Tevfik Bilgin, the banking regulator, has sided with them. If nothing else, he should be aware of the large academic literature linking fast credit growth to banking crises, to which one of the previous vice presidents of his agency was an early contributor.

In Turkey’s case, the credit growth is contributing to the country’s growing current account deficit as well. For example, there is a strong relationship between consumer credits and consumption good imports.

But tackling credit directly is hardly enough. After all, the other side of the coin is capital flows: The current account deficit is growing only because it is financed by the capital account. Normally, one would not worry about money pouring in from outside if most of it were foreign direct investment rather than short-term portfolio flows.
Such hot money not only creates pressures on the lira, but also contributes directly to domestic credit growth, as CBT President Durmuş Yılmaz explained Friday: The foreign money pours into Turkish assets (government bonds or equities) or just parks short-term in the money market. The latter ends up as credit via swap operations with the local banks.

And that’s what Thursday’s CBT policy rate meeting is all about. By cutting its overnight borrowing rate by 4 percentage points to 1.75 percent, the CBT is nudging local banks with excess liquidity to lend to other banks rather than put their money overnight at the CBT. They could also shift to government bonds, but money market, or overnight, rates are likely to fall in any case.

As a side product, short-term foreign flows to the money market will be discouraged, effectively shutting off this credit creation mechanism. To the extent that at least some of these carry traders will shift to government bonds, the move is not likely to fend off capital flows or ease the pressure on the lira by much. But it is likely to bring in some volatility to both interest and exchange rates.

In fact, the Bank is explicitly saying that overnight rates could diverge from the policy rate in both directions. While they could in principle fall to as low as 1.75 percent, the CBT, as a net liquidity provider, directly controls how far they will go. For example, if hot money continues to pour in, and the CBT does not sterilize these flows through reverse repos, overnight rates could drop significantly.

However, a tightening of liquidity could lead to overnight rates shooting above the policy rate as well. End-month tax payments and the new reserve requirement will squeeze liquidity after the Bayram. In addition, Treasury auctions of the same week are likely to drain liquidity, as the Treasury has only 757 million liras of redemptions. If the CBT were also to cut the amount of one-week repos, money market rates could rise sharply.

In essence, overnight rates could go up or down. Such uncertainty and the accompanying volatility is perhaps the best way of taming in hot money and credit growth.

Emre Deliveli is a freelance consultant and columnist for Hurriyet Daily News & Economic Review and Forbes as well as a contributor to Roubini Global Economics. Read his economics blog at


Rower32 said...

That's a nice looking V-Shaped capital acct chart there. Lemme make a bold prediction: the TTM flows will hit $90-100bil by May 2011. Two major plays right now are EM growth and commodities. The EM managers i talk to LOVE Turkey. It's such a success story in their eyes (and i partly agree) and you know how they love winners here in the states.

Anyways, maybe you are right and we'll see higher CPI prints in the next couple quarters. I think more troubling chart is seasonally adjusted unemployment rate. It's good to look at the long term trend here. Now I don't know how the stat agency calculates unemployment rate in Turkey. Would be nice to see civilian participation rate& labor force #s. Maybe some of the marginally attached workers coming back to the labor force, I don't know. We'll see how that evolves. Thanks for the insight.

Emre Deliveli said...

Hi Rower32,

I responded to your comments/questions with a post: