Taking Stock of the CBT’s Policy Mix

ACHIEVEMENTS

Volatile money market rates and intentional ambiguity on policy stance As a result of the policy rate cuts and widening interest rate corridor, rates in the secondary market for repos fluctuated intensely and deviated from the policy rate for a longer period of time. Within November-December 2010, the 10-day average of the O/N repo and 1m swap rates hovered below the policy rate. Meanwhile, the CBT left the door open for additional rate cuts, a move that we feel was intended to impede a clear understanding of the Bank’s policy stance, hence to make any positioning more difficult.

Heavy outflows from short-term bets; partial shift to longer maturities Based on the BRSA’s off-balance sheet data for the banks, cumulative outflows from Turkish markets have reached US$11.5bn in between the MPC meeting held in November and the end of February. Short-term fund outflows are noted to be mainly the result of the closure of money market positions of the non-residents, in the form of swaps, deposits, repos and credit transactions. A partial return of these flows caused a shift in non-residents’ positions within November 2010 – February 2011 in favour of longer maturities, mainly through accumulation of domestic debt instruments.

Banks’ reliance on short-term funds is on the rise; so is the interest rate risk... Before the recent agressive hike, the CBT increased TRL reserve requirement ratio (RRR) gradually three times and withdrew TL19.5bn cumulatively. This has brought the CBT funding through 1w repo auctions to the TL25-30bn range recently. Since the March RRR hike will have taken effect on April 15, 2011, liquidity to the tune of about TL19.1bn will be withdrawn from the market and will pull the total funding from the CBT up to the TL45-50bn range. Contrary to speculations about insufficient liquidity injections by the CBT, we think the monetary authority needs to provide the liquidity demanded in the market, to
maintain money market rates close to the policy rate. However, banks will become more dependent on very short-term Central Bank resources despite additional funding. Hence, even when banks’ loan levels remain unchanged, their maturity mismatch
will increase. Banks will have to reflect the additional interest rate risk to their loan rates and/or scale back their loan portfolios.


FAILURES

Decline in TRL deposit rates; no increase in TRL loan rates...Banks had the chance to scale down the interest rate of the deposit whose cost had increased, given full substitutability of short-term Central Bank funds with deposits. Thus, the rise in the cost reflected more on deposit rates than on loan rates, at least before the latest hike in RRR.

Although this 400bp increase may be a game changer, the data on the average interest rate on loans for the March 25 week, when the MPC meeting took place, are not promising. Only the interest rate on commercial loans increased by a considerable
37bp to 8.78%. While the cash and vehicle loan interest rates even declined by 7bp and 5bp to 11.97% and 10.51%, respectively, the interest rate on housing loans increased by an insignificant 3bp to 9.76%.

Loan growth is still strong on all metrics...
Despite all the measures adopted, the slowdown in loan growth is still not significant, as total loans are increasing at an annual rate of 41% and consumer loans at 35% as of March 25. We also think the exchange rate effect on FX loans should be neutralised by using fixed FX rates against the TRL and a fixed
currency (60% US$-40% €) composition. We took the last 22 business days’ average of total loans (fixed FX rates and fixed FX composition) to represent the monthly outlook and compared it with the average of the same period a year ago. The annual
increase in our indicator is still high at 34.7% as of end-March.

Where to henceforth?
Too early to call a cease-fire... Considering the achievements versus failures of the CBT’s policy mix, it would be somewhat premature, in our view, to expect the monetary authority to refrain from adopting further tightening measures, until there is conclusive evidence of a slowdown in loan volume and domestic demand.

The Central Bank bought time; but the window of opportunity is a narrow one... The CBT expects the restrictive effects of these policy measures to be observed with a lag, possibly starting with the second quarter. The monetary authority also bought time by launching front-loaded RRR hikes with its recent move. Moreover, it called for supplementary macro-prudential measures targeting credit supply from other institutions (read as BRSA) to extend the wait-and-see period. However, this window of opportunity is not wide open: now is the time to observe more concrete developments (rise in deposit and loan rates) -- even before the major liquidity withdrawal takes place.

CBT drives short-term rates up; pressures the banks... As one of the channels (cost) for transmission of RR is not working, the CBT relied heavily on the other (liquidity) channel. Further liquidity withdrawal on April 15 and a wider interest rate corridor provide the CBT with the opportunity to drive O/N rates wherever it wants them to be. Within November-December, the CBT’s aim was to discourage portfolio inflows; hence, O/N rates fell sharply. But now, the main concern is relentless loan growth; so the CBT is driving the rates to the upper limit (Primary Dealers Facility, which is at 8% vs. policy rate of 6.25%) of the interest rate corridor. However, we need to acknowledge that this cannot be a permanent strategy in an Inflation Targeting regime, where the Central Bank has to provide the liquidity demanded in the market, to maintain money market rates close to the policy rate. Otherwise, the policy rate will lose its significance as a reference rate.

Is it early for FX RR hike?... Up until now, the CBT used TRL RRR as its main policy tool. However, now the average weighted RRR stands at 13.4%, higher than the uniform FX RRR of 11%. Meanwhile, banks increased their FX deposit rates and were granted permission to issue FX bonds. This creates the perception that RRR hikes in FX deposits might be in the pipeline. Also as expected, the coverage of the liabilities subject to RRR may be expanded and the RRRs may be differentiated according to the nature and maturity of liabilities, including the off-balance sheet liabilities (mainly swaps) of the banking system. We do not
think we are there yet, especially in terms of RRR hikes that withdraw FX liquidity, since banks are still not comfortable, as the “claims from abroad” account has halved to US$12.5bn during the hot money outflows and remained at that level since then.

Swap RR also likely... On the other hand, we have been observing inflows through swap transactions since the start of March, due to attractive money market rates. Over the last four weeks, cumulative inflows have amounted to US$8.8bn, corresponding to almost 70% of the outflows within November-March. Since March 4, the TRL has appreciated by 5.7% against the US$. This picture could compel the CBT to act by broadening the coverage of liabilities subject to RR to include off-balance sheet items.

New Governor, Old Bank... As the quarterly inflation report will be published in April, the MPC meeting on 21 April, under the presidency of the new governor, has become more crucial. As a reminder, the CBT’s baseline scenario in the previous report envisaged a gradual tightening this year by changing the mix of the policy rate and RRRs. According to the CBT, monetary tightening could be implemented either through RRRs or policy rates, or a combination of both. Until now, the RRR leg of the policy mix has been used and its impact through the liquidity channel has been relied upon. Although we do not expect further TRL RR hikes in the short-term, we see some room if necessary and expect the usage of untapped FX related measures
including FX buying auctions. However, in the absence of any meaningful slowdown in loan growth and domestic demand, despite all the measures taken to date and discussed above, the recent positive inflation outlook could only delay an inevitable
policy rate increase by a few months.