On Dec. 17, one day after the Central Bank of Turkey decided to cut rates, an article titled “Turkey’s Financial Conundrum” was published in the Wall Street Journal. Although it displayed opposite views about the decision and refrained from early judgment, the tone of the article was rather cynical as you might also extract from the sentence below:
“The bank’s monetary policy committee on Friday completed the second act of a hocus-pocus plan to simultaneously slow booming credit growth and curb the inflows of hot money that’s threatened to destabilize Turkey’s rapid recovery. Policymakers in Ankara have gambled that cutting rates to dissuade speculative investors is less risky than firing a domestic consumer boom that some fear could see the economy overheat. It’s too early to judge whether the complicated policy shift will have the desired effect: reducing hot money flows and cooling runaway lending rates. But the policy push has split the market. Some have praised the [Central Bank]’s boldness, acknowledging that rate-setters are in a tough spot trying to square competing objectives. Others are less sanguine, warning that the abrupt shift in policy calls the bank’s credibility into question.”
In an environment of uncertainty and unconventional approaches to monetary policy globally, as well as general elections and a Central Bank governor change locally in 2011, one could easily understand why there are different views and second thoughts about the same decision. Exactly for that reason, in my previous article, I underlined the importance of the Central Bank’s credibility in the eyes of market players since measuring how much increase in required reserve ratios would be enough to offset the interest rate cut is not very straightforward. If you want my honest opinion, the Central Bank has built up huge credibility during the global crisis by starting pre-emptive rate cuts that later on many others followed. So I beg to differ from those who see problems and risks in this policy mix. Clearly, the Central Bank is planning to ride on possible positive surprises from the inflation front. I can imagine how skeptics might react if headline inflation fell rapidly and reached 5 percent or lower at the end of February next year. The first test for this strategy will be held with December inflation, where I expect another fall in year-on-year comparisons. This could mean success for the Central Bank in reaching the 2010 target of 6.5 percent.
Capital war advances in all fronts
In the Monetary and Exchange Rate Policy announcement for 2011, on Dec. 21, the Central Bank said it would continue with the policy to increase the reserve requirement gradually for short-term Turkish Lira liabilities and also may consider changing the reserve requirement of foreign currency liabilities according to maturity composition. This implicitly means that the bank will continue with policy rate cuts in the following meetings to smooth the tightening effect of the reserve requirement increase. Another move from the Central Bank could be to widen the scope of the reserve requirements for foreign exchange liabilities. In that context, the Central Bank said banks’ off-balance sheet activities are going to be monitored closely. This means that the Central Bank may consider applying reserve requirements to FX swaps, which is another source for creating cheap Turkish Lira funding.
New target for Central Bank?
With its recent precautions and mention of possible measures it could take, the Central Bank seems to have adopted an implicit target for the current account deficit, as they expect it in 2011 to approach the level forecasted in the Medium Term Program ($42.2 billion, or 5.4 percent of GDP). However, consensus expectation for 2010 suggests the current account deficit will approach $45 billion this year, thus making such an assertion quite ambitious. Moreover, reaching this target necessitates a significant slowdown in economic activity especially in domestic demand. Therefore, striving for a narrower current account deficit would eventually mean prudent policy making thus confidence-boosting development for the government in an election year.
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