Monday, February 7, 2011

Preview for the addendum to the Hurriyet column

Since I have a very early flight tomorrow morning, I will not be able to do the addendum to my latest Hurriyet Daily News & Economic Review column that I had promised until tomorrow night or so. But in the meantime, let me just sketch out my ideas. 

At the heart of Central Bank's policy strategy lies the banking sector. This is so because even if hot money comes to a virtual halt, the current account deficit will continue to soar if banks continue to lend- that's when we crash-land, meaning that either output or the exchange rate will end up adjusting very strongly, probably the latter, at least at first. Moreover, if banks do not adjust their balance sheet in accordance with the CBT's simultaneous control of the price and quantity of liquidity, the market interest rate will be different from the policy rate. That is something which the CBT can tolerate, to some degree at least, or maybe even favor, as I explain below. But then what is the point of cutting the policy rate?Actually, there is a subtle point, which I turn to next.

What changes would I expect to see in the banks' balance sheet because of the CBT's policies? Let me start with the FX side, as it is easier: For one thing, as a direct result of the CBT's policies, banks' FX claims from abroad should have fallen. On the domestic front, there has been some retail sell-of in the past two months, so in accordance with this change in the banks' balance sheet FX position, their off-balance sheet positions should have decreased as well- this phenomenon is not recent; banks' on and off balance sheet FX positions are exactly mirror images of one another.

At some point, this need for FX liquidity would make banks turn to receiving cross currency swaps- or at least unwind payer positions- does not make sense to allocate dear FX liquidity to swaps, right? But note that until a few months ago, that was how banks made their balance sheets grow, by accumulating payer swaps on the liability side. Anyway, as a result, FX swap rates would stay low, making sure that the lira does not become an attractive carry currency again. This process would naturally be hastened if the CBT were also to hike required reserves for FX. BTW, this is what the CBT means by a low external equilibrium interest rate.

And since deposits are unlikely to move much, banks could make up for the changes in the liability side by issuing bonds. Bonds are cheaper to borrow for banks than cross currency swaps, so bond issuance will enforce the mechanism noted above. I noticed this when I got Garanti's press bulletin about their latest bond issuance on Saturday, so they receive my blessings for sparking the light bulb inside my head. In sum, you should think about the recent bank bond issuance as part of this game-set...

And last but not the least, there is the CBT providing liquidity on the liability side. This is a typical mustache-beard dilemma, as the Turks would say (it is the mustache if I spit upwards, the beard if I spit downwards): If the CBT continues providing liquidity to the system at the policy rate, banks will not hesitate to make lending out this liquidity. If it doesn't, market rates will be above the policy rate, but maybe this will be good by bringing yet more constructive ambiguity and signaling that, on net, the CBT is tightening.

The problem is that as it is, with the average maturity of deposits only a couple of months,  there is not much difference between deposits and CBT money in terms of maturity mismatch when banks lend the funds. In fact, that's why the CBT would like to extend the maturity of deposits, but with 40 percent of total deposits concentrated in 30,000 accounts over 1 million liras, it is a depositor's world out there, they have the last say in this matter, even after they are appropriately incentivized:) This structure explains why banks have to fight hard for deposits. And if the banks are not able to lower their deposit rates because of competition, they will either have live with lower profits or pass on the reserve hikes to lending rates. BTW, this is what the CBT means by a high internal equilibrium interest rate.

Now, you can see why I am critical of the Bank's communication of late: All this is as complicated as it is, but referring to this convoluted process as simply "dual interest rate to achieve internal and external equilibrium" is likely to make things even more complicated.

So far so good. From what I have written so far, what the Bank is trying to achieve on the FX side seems to be rather straightforward. The lira side is a bit trickier, as it seems that credit may continue to be flowing even with higher lending rates, as it makes sense for banks to lend more. Moreover, with the economy in still recovery mode and confidence signals strong, there is not much support coming from the demand side, either.

Unfortunately, there is not much support from the asset side of banks' balance sheets, either: As they scramble for liquidity, the first to get loaded off balance sheets should be government bonds. After all, government bonds are not as good a deal as credit, especially in the current monetary policy outlook. So we should see some of the recent government bond sell-off get channeled into credit, but that's not what the CBT wants! Uppssss......

Finally, remember that the government is criticized a lot for not enacting capital controls. Just think what in this story would change if there were capital controls? Not much!

This is all me storytelling. In a day or two, I will be do another addendum, where I will provide some figures and charts to support my story. After all, a picture is always better than a thousand words, and I am almost at a thousand words!:)...


Anonymous said...

Dear Emre,

What happened to your new blog idea about expats living in Turkey?
You seemed so enthusiastic about it.


Emre Deliveli said...

I am, I am... Travel, illness and the like kept me busy, but your note got me motivated again. I promise I'll get it going early next week at the latest...



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