The Central Bank is finally taking action against the expanding current account deficit, which is perceived as the most significant threat against the financial stability, a phenomenon that is as important for the Bank as sustaining the price stability. Ahead of the Monetary Policy Meeting on December 16 and the 2011 Monetary and Foreign Exchange Rate Policy due December 21, the Central Bank used all the communication channels to give the message that the monetary policy stance may change. To justify this shift in the monetary policy the Bank says that the additional monetary easing in developed countries magnifies the risks of boosting capital inflows and further widening current account deficit. The Bank states that the current account deficit may grow through two channels; an acceleration of credit, domestic demand and demand for imported goods, due to an increased availability of ample low-cost borrowing opportunities, or an acceleration of demand for imported goods due to the current real appreciation trend of TRY reaching levels that are inconsistent with economic fundamentals. The Bank describes the new monetary policy framework in this environment as tightening via macroprudential instruments to prevent acceleration in credit, while reducing short-term interest rates in a controlled fashion to curb the appreciation trend in the exchange rate. The Bank believes this is the ideal policy mix. Now, we have an idea about the general terms of the new policy framework. However, there are question marks as to how much the Bank would cut the policy rate and raise the reserve requirements. I will try to answer these questions. The level of the real interest rate would mark the lower boundary for the policy rate, while CBRT Deputy Governor Basci gave the first clues regarding the macroprudential tools in his presentation held at the last weekend. The foremost objective of these measures is to provide incentives for the extension of maturities in all types of funding the Banks obtain from sources other than the Central Bank, while containing the money and the credit growth. Below I mention the first possible steps and my assessments regarding them in parentheses.
The financial stability measures to extend maturity: The purpose of the new measures will be to provide incentives to longer maturities for depositors as well as for international investors.
- Short-term deposit rates will settle at levels significantly below the longer term deposit rates. (This can be achieved by setting higher required reserve ratios for short term deposits, as well as by the policy rate cuts.)
- The CBT will take the necessary steps so that the average level of the short-term swap rates will form below long-term swap rate averages, while the volatility of short-term swap rates will materialize above those of the long-term rates. (While the swap rates would normally trade below the money market rates, by cutting the O/N borrowing rate to 1.5% and by letting the O/N repo rates to temporarily deviate from the policy rate the Central Bank already prepared the ground for this environment)
Financial stability measures to contain money and credit growth are as follows:
- The fall in long term interest rates is expected to be much more limited than that in short term interest rates. (The long term interest rates are what really matters for the credit rates. Therefore, if the Central Bank, by successfully managing the expectations, achieves to prevent the long term rates to decline as much as the policy rate cut, this may limit the credit growth.)
- The required reserve ratios will be increased primarily and especially for short term liabilities in gradual manner. (Given the fact the average maturity of deposits is 1-month, setting a different required reserve ratio for that segment may be an effective policy. In the meantime, the Bank now expands the funding channels of banks that are subject to required reserve to include the repo transactions)
- For containing the widening of the current account deficit, other public authorities in Turkey should also provide incentives for the extension of maturities in all types of funding while moderately and gradually tightening their macroprudential instruments. (Here, the Bank calls other institutions such as Finance Ministry and BRSA to use taxes and other instruments for the same purpose)
- The Central Bank will continue to tighten and loosen the short term funding amount at the policy rate as required by the circumstances. (The outstanding funding the Central Bank provides for the banking system hovers at TRY20bn and the level of O/N rates are affected by the changes in the funding size)
Some of these measures have been in use for some time, while some others are put into force at the Central Bank’s last MPC meeting and the remaining items (the new rules planned to motivate long term corporate bonds and eurobonds) on the list would be introduced depending on the ability of the economy officials to collaborate and synchronize.
On the other hand, the Central Bank believes that the significant drop in Turkey’s risk premium, the sharp decline in inflation expected in the following months (I anticipate CPI falling below 5% by February) and the likely acceleration in the portfolio inflows would give enough space for rate cuts. I assume that the real interest rate adjusted by the risk premium would determine the size of the rate cuts, which would be “measured” according to the Central Bank’s rhetoric. Even if the policy rate remains unchanged, real interest would rise if the risk premium and/or inflation expectations ease, the implication being a tighter monetary policy. The current risk premium of Turkey (that is 170 bps as measured by the EMBI+ Turkey) gives room for 150 bps rate cut in order to bring the monetary policy back to the loosest stance observed in the first half of the year (when the real interest rate was a negative 2.7%). This gives us the maximum amount of rate cut that is possible. As other criteria, the Central Banks says that the net impact of the measured policy rate cuts and tighter macroprudential tools to be contractionary. However, measuring how much increase in required reserve ratios would be enough to offset the interest rate cut is not very straightforward and the Central Bank’s credibility would play an important role. I believe that the Central Bank has been very credible for the markets over the recent period and I do not expect any problem on this side.
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