Central bankers in emerging markets are discovering that they cannot achieve the twin goals of price and financial stability with the single tool of short-term interest rates.

The post-Lehman era is on the way to becoming one of the longest recessions that the global economy has ever experienced. While common logic suggests that any recovery from a deep financial crisis will be both long and painful, there was still a widespread hope that the measures taken by policy-makers would have started to turn things around by now. But instead, the fragilities in the world economy just moved from the financial sector to sovereign balance sheets. Although the picture may seem bleak for the future, the lessons learned by these policy-makers could pave the way for a more resilient global economy in the years to come. The key thing to take away from the global crisis is the indispensable role of financial stability in addition to price stability for central banks.

Many emerging economies experienced a robust, demand-driven recovery soon after the onset of the crisis, while the recovery in advanced economies, more than three years after the Lehman Brothers collapse, is still fragile. However, during this period, low interest rate levels in advanced economies, together with the large-scale securities purchase programmes of major central banks, boosted short-term capital flows into emerging markets and exacerbated the imbalances in the pace of recovery between domestic and external demand in these economies, accumulating financial stability risks. These flows placed appreciation pressure on emerging market currencies while accelerating credit growth in emerging markets.

The challenge of achieving two goals – namely price stability and financial stability – by using only one policy tool – short-term interest rates – is an impossible one. The interest rate level required to ensure price stability may not necessarily be the same as the interest rate level needed to preserve financial stability in many circumstances. Hence, the adoption of multiple objectives necessitates the utilisation of alternative policy instruments and macroprudential tools to supplement the conventional short-term interest rate instrument.

Short-term problems

The bipolar structure of the global recovery, together with globally excess liquidity conditions due to 'low for longer' interest rates in advanced economies, have had significant implications for the Turkish economy. It has experienced a strong, domestic demand-driven recovery since mid-2009, thanks to the country's sound household and banking system balance sheets.

The challenge of achieving two goals – namely price stability and financial stability – by using only one policy tool – short-term interest rates – is an impossible one.

Erdem Basci

However, the weak recovery in advanced economies has led to the country's exports remaining depressed, resulting in a widening current account deficit. Despite this, rapid credit growth driven by excess global liquidity led to an appreciation of the Turkish lira, exacerbating the divergence in the pace of recovery between domestic and external demand. Rapidly widening current account deficits and excessive credit growth raised concerns about the effects of any sudden reversals in risk appetite, which could cause financial instability.

Aware of the conditions created by the new global economic conjuncture, the Central Bank of Turkey (CBT) decided to modify its existing framework of inflation-targeting by explicitly highlighting the increasing role of financial stability in its objective function. Accordingly, the CBT adopted a new policy mix by using alternative policy tools, such as reserve requirement ratios and an interest rate corridor, to supplement the short term interest rate. In this context, the CBT has been implementing policies with the objective of gradually leading Turkey's economy to robust growth without hampering the medium-term inflation outlook. Accordingly, policies were pursued to prevent an excessive deviation of exchange rates from economic fundamentals in either direction, while necessary measures were taken with the support of other institutions to ensure reasonable loan growth rates.

However, it is impossible to achieve both goals simultaneously by only adjusting the policy rate, as higher policy rates would most likely attract further short-term capital inflows that would contribute to the build-up of macroeconomic imbalances. Hence, raising interest rates was not the optimal response under the global conditions prevailing in the second half of 2010. In this context, the first pillar of the policy response was reducing the incentives for the interest rate carry trade and lengthening the maturity of capital inflows.

Together, these policies aimed at improving the quality of the capital account, limiting maturity mismatches and avoiding exchange rate misalignments. To achieve this, the CBT widened the corridor between overnight borrowing and lending rates downwards, introduced some volatility in the short-term interest rates and reduced the policy rate by a total of 75 basis points. Increased downward volatility in the overnight rates induced by the new policy framework was aimed at reducing the expected risk/return ratios from carry trades and discouraging short-term speculative inflows.

Maintaining price stability

In order to offset the potential expansionary impact of policy rate cuts on domestic absorption, the CBT embarked on a quantitative tightening strategy, basically aimed at directly controlling the amount of liquidity and moderating the rapid credit expansion. Slowing credit growth was seen as a key intermediate objective of this policy response as it would support both the financial and price stability objectives.

To this end, the CBT started using reserve requirement ratios as an unconventional policy tool. First, remuneration of reserve requirements was halted in order to increase the effectiveness of the reserve requirement ratios as a policy tool. Next, the CBT started hiking reserve requirement ratios significantly, with varying degrees across maturities, and broadened the coverage of liabilities subject to reserve requirements.

The hikes in reserve requirement ratios led to a significant level of Turkish lira liquidity withdrawal from the banking system. As a result of this strategy, the maturity of the liabilities of the banking system increased, supporting financial stability via reductions in the roll-over and interest rate risks of Turkish banks.

Another aim of the new policy strategy was to avoid potential exchange rate misalignments caused by short-term speculative inflows – partly driven by exceptionally loose policies implemented in advanced economies – as well as rapid outflows. Following the adoption of the new policy mix, appreciation pressures reversed and the behaviour of Turkish lira differed significantly from the currencies of other emerging economies, in the desired direction. This development was intended to reduce macro-financial risks by leading the economy to a more balanced growth path, mainly through a slowdown in import growth and a modest recovery in exports.

Crisis response

In the third quarter of 2011, mounting concerns regarding sovereign debt sustainability problems across the eurozone, coupled with the slower-than expected recovery in the US real estate and labour markets, intensified the downside risks for global economic activity. Accordingly, economic forecasts were revised downwards and expectations for a further delay in the normalisation of monetary policy in advanced economies grew stronger. Mounting uncertainties regarding the global economy and the deterioration in risk appetite led to capital outflows from emerging economies. This outlook not only fed into short-term inflationary pressures in emerging economies, but also highlighted concerns over growth and financial stability.

Under conditions of extreme global uncertainty, monetary policy-making is a challenging task which requires acting in a timely manner by utilising alternative policy tools and being prepared for different scenarios. In the light of the experience acquired during the 2008 global crisis, the CBT reacted promptly after the heightening of the financial turmoil in August 2011, with an interim meeting of its monetary policy committee in order to contain the potential adverse effects of these developments on financial stability and economic activity, and announced a comprehensive package of measures. The CBT first narrowed the interest rate corridor and then widened it in October 2011, upwards this time, to mitigate against renewed inflationary pressures despite a global slowdown. These measures laid the foundations for a timely, controlled and effective provision of liquidity to markets in the event of financial turmoil due to developments in the global economy.

The CBT also decided to provide necessary liquidity support to the banking system to contain the adverse effects of the prevailing global problems on domestic financial markets. Overall, these measures aimed at setting out the framework for a timely, controlled and effective provision of liquidity to the market in the event that global uncertainties triggered financial turmoil, and hence containing downside risks for the Turkish economy to a considerable extent. Besides, by acting in a preemptive way, the CBT sent a message that it is ready to support the smooth functioning of the financial markets under different scenarios, which has been well received by market participants.

As a final word, we are going through a period in which central bank policies have to be flexible in dealing with the existing global uncertainties. In this context, Turkey has been actively utilising an interest rate corridor, reserve requirement ratios and liquidity management in order to deal with the complexities of the current global economic environment.

Erdem Basci is governor of the Central Bank of Turkey

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