Monday, December 20, 2010

Weekly Hurriyet Column: ‘Confuzzled’ by the Central Bank

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. As for the title, it is a quote from a great movie I watched recently

As for an addendum, I don't have much to say for a change, except that interested readers can refer to my recent Roubini Global Economics contribution, where I elaborate in detail on some of the points I make here. But I need to recommend a must-read compliment to my writings: I mention several times, explicitly or implicitly, that hiking the reserve requirement is likely to increase the credit interest rate marginally and could even increase the quantity of liquidity. The reasoning for the former is that banks could pass over the hikes to deposit rates or just live with lower profits, if depositors are able to wield their power. As for the latter, the idea is that the Central Bank, by lowering the policy rate, guarantees providing liquidity at this rate; if it doesn't the market rate will go up. I just found out that blogger and economist Chevelle expands on this compact explanation at her blog Models & Agents. Since the editors at RGE brought the piece to my attention, I am duly linking it to the RGE Economonitor version of this excellent piece.

Without more delay, on to the column:

The Central Bank of Turkey, or CBT, did not surprise at all on Thursday when it cut the policy rate from 7 to 6.5 percent. Friday’s reserve requirement hikes were in line with expectations as well.

At first, markets did not take the hints at the Bank’s Financial Stability Report on Dec. 7 seriously. That’s when Deputy Governor Erdem Başçı, calling in a last-minute weekend meeting at the Turkish Economic Association, clearly spelled out the Bank’s new policy strategy. It is necessary to explain the rationale behind the measures before discussing whether they will work.

The Bank is reacting to liquidity emanating from the quantitative easing of the developed world finding its way to Turkey in the form of short-term capital flows. As the other side of the same coin, the current account deficit is growing from two distinct channels: First, because of the cheap and abundant borrowing, credit, domestic demand and imports are rising. In addition, imports are shooting up because of the real appreciation of the lira.

The Bank argues that increasing the policy rate, while reducing the current account deficit from the first channel, would have the opposite effect from the second channel: Higher interest rates would bring in more hot money and appreciate the lira even further. Therefore, it is tightening non-interest tools, like reserves, to curb credit growth, while at the same time decreasing the policy rate to limit currency appreciation.

When explained in this way, it looks quite plausible that the measures will actually work. But the devil is in the details, and when I look at the details, I can see many reasons to be confuzzled, i.e. confused and puzzled.

For one thing, one of the main objectives of the Bank’s new measures is to extend maturities of domestic and foreign borrowing and deposits. The CBT’s earlier measures have already been successful to some degree towards that goal. For example, the share of overnight in repos has decreased from one half to one third in the past month.

But the average maturity of deposits is only a couple of months, with 40 percent of total deposits concentrated in 30,000 accounts over 1 million liras. Given depositors’ power, the measures could be ineffective, or even reduce the marginal propensity to save rather than push deposits to longer maturities, as the Bank is hoping, worsen the country's private savings problem and widen the current account deficit further.

Besides, new lending is only partly financed by repos or domestic liquidity. So it is not all that clear how effective these measures targeting onshore liquidity will be as long as offshore liquidity continues to pour on.

That’s where the rate cut is supposed to help, but as the IMF is underlining in a recent note, expectations that interest rates will remain low would encourage financial and real sectors to lengthen their duration mismatches. That’s why the Bank has made no explicit reference to the future trajectory of policy rates on Thursday, but I doubt it will be enough.

Similarly, the Bank’s liquidity management is contradicting its new framework as well. For example, the CBT is not addressing base money growth through open-market operations, or fully sterilizing its foreign exchange interventions, as it knows doing so would create upward pressures on interest rates.

All this conpuzzlement could have easily been avoided: As the Fund emphasizes, “a tighter fiscal policy [would] lessen demand for resources, decrease pressure on prices and imports, and by raising government deposits, support the CBT’s efforts to absorb liquidity”.

Unfortunately, that is ruled out by the general elections, leaving us with risky policies with uncertain consequences.

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

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