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Western EuropeMay 4 2011

Uncertainty reigns as Turkey takes two-pronged monetary policy approach

Turkey’s central bank is attempting an unusual combination of tightening monetary policy using reserve requirements, while combating speculative inflows through interest rate cuts. But the outcome remains uncertain.
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Uncertainty reigns as Turkey takes two-pronged monetary policy approachDurmus Yilmaz, Turkish central bank governor

When Durmus Yilmaz hands over the reins as governor of the Central Bank of the Republic of Turkey (CBRT) to his deputy Erdem Basci after completing his five-year term in April 2011, he will leave behind a remarkable legacy.

Consumer price inflation, which surpassed 70% in 2001 and was still at 9.6% when Mr Yilmaz took charge in 2006, came in at just under 4% year on year for March 2011, the lowest rate in more than 40 years.

Since inflation-targeting was introduced after the 2000-01 banking crisis in Turkey, the CBRT has hit its target in six out of nine years, and the latest data suggests that the 5.5% target for 2011 is also within reach – the third year in a row that its target has been met.

 

This has given the CBRT the kind of credibility that is vital for managing price expectations, and therefore price-setting behaviour, among economic participants.

Strategic questions

But recent events have raised questions about whether the monetary authority is still operating a pure inflation-targeting regime. Gross domestic product (GDP) grew by 8.9% in 2010, and bank credit rose by about 44%. The country’s current account deficit is widening sharply, more than doubling year-on-year in February 2011, to reach 7% of GDP for the previous 12 months.

Despite these signs of a rapidly heating economy, the central bank cut its benchmark one-week repo rate by 50 basis points (bps) to 6.5% in December 2010, and by another 25bps in January 2011. To rein in credit growth, it hiked the required reserve ratio (RRR) on deposits from 8% to 10% at the same time as the second interest rate cut, and then by a further 400bps in March 2011. This macroprudential tool raises the cost of deposit funding as a way to curb the banks’ appetite to lend.

The CBRT has justified its reluctance to follow the more conventional path of interest rate hikes by pointing to the heavy speculative inflows to emerging market currencies that carry higher interest rates. Even if the central bank accumulates foreign exchange reserves, some of these inflows would leak into the economy and fuel inflation and the current account deficit.

But Selim Cakir, chief economist at Turk Ekonomi Bankasi (TEB) and a former official at the International Monetary Fund (IMF) and Turkish Treasury, compares the dual policy to a car driver pushing the accelerator and the brake at the same time. “If the central bank had only hiked reserve requirements, then the policy would not have been so unorthodox, and it would have been easy to claim that this was monetary tightening. The confusion came from their decision to cut interest rates at the same time, but at least the new reserve requirement hike [in March] is unambiguously a tightening move,” he says.

Unintended consequences

Even after the extra RRR hike, however, there is widespread scepticism about whether the CBRT policy will work. The rate cuts look insufficient to stem foreign portfolio inflows to the Turkish lira as long as US interest rates remain at less than 1%. At one stage after the January interest rate cut, the lira lost about 5.4% of its value against the US dollar (to about Tl1.617 per dollar), which should in theory shake out some speculative investors.

But the currency is already recovering. Werner Gey van Pittius, a portfolio manager for the $7.5bn Investec emerging market debt fund that is mostly invested in local currency debt, says that about $95bn in dollar deposits held by Turkish corporate and retail customers act as natural stabilisers for the currency – especially because many are structured as dual currency deposits.

“These deposits will pay up to 4% annualised rates on dollars, and the bank will then write calls on the dollars at about Tl1.60. So if the dollar rallies beyond that, the depositor will be switched into lira, which caps any potential market fall in the lira. If the dollar does not rally, depositors will keep the dollars and earn the option premium from writing the call, which means they can be paid an 8% or 9% interest rate on dollar deposits, which is of course very attractive,” says Mr van Pittius.

Moreover, banks are turning to wholesale funding to avoid the reserve requirements on deposits. Since the regulators approved renewed bank Eurobond issuance last year, Akbank (twice), Isbank and Yapi Kredi have all tapped the market, with Garanti expected to follow to complete the set of the four largest private sector banks. International syndicated loan raising and local market debt issuance have also picked up.

“The RRR hike is not a substitute for an interest rate hike. It does not lead to a material change in the expectations of economic agents, it just changes the risk/return characteristics of the banks, and they change their funding profile,” says Eralp Denktas, a portfolio manager at the Tl8bn fund manager Ak Asset Management, who recently produced a doctoral thesis on monetary policy and asset bubbles.

Credit from abroad

The RRR has indeed done little to discourage demand for loans from customers. Mr Denktas says companies may seek credit directly from abroad if it becomes less available from local banks. Meanwhile, more intelligent retail borrowers realise that an interest rate hike is likely to follow eventually, so they may be bringing forward their mortgage and loan applications to lock in the current low rates.

“We have to support the central bank in its monetary policy, but in a country such as Turkey, the demand for banking services overrules other ideas, especially for mortgages. In Istanbul, good standard housing is of the utmost importance given the earthquake risk, and we have a young society where the definition of the household is rapidly changing,” says Ersin Özince, who stood down as CEO of the country’s largest bank, Isbank, in April 2011 to become its chairman instead.

The reluctance of banks to change their behaviour is further intensified by the knowledge that there is little room for the CBRT to reduce lira liquidity in the market any further.

To avoid the interbank market becoming illiquid and short-term rates moving significantly above the CBRT's policy rate, the central bank has needed to inject liquidity that offsets the additional amounts placed in reserve by the commercial banks – now about Tl50bn in CBRT repo auctions, equivalent to about 5% of GDP.

“It looks rather odd for a very healthy banking system to become so dependent on central bank liquidity injections – this policy choice is not costless,” says TEB's Mr Cakir.

Turkey inflation and expectations

Turkey inflation and expectations

Political tensions

There is a suspicion that the central bank may have shied away from interest rate hikes not for economic reasons, but because it does not want to rock the boat ahead of parliamentary elections in June 2011.

The sentiment intensified when deputy prime minister Ali Babacan made a speech in March 2011, warning that the government will consider unspecified enforcement measures if banks do not adhere to the CBRT’s guidelines of 25% loan growth in 2011. This provoked complaints that Mr Babacan is trying to transfer responsibility for cooling the economy from the authorities directly on to the banks.

Gazi Ercel, an independent economic consultant who was Turkey's central bank governor from 1996 to 2001, feels that the concerns expressed by the monetary policy committee about foreign inflows to the lira merely provide a story to explain the interest rate reduction.

“The definition of this so-called hot money is unclear, as is its relationship to moves in the exchange rate”.

Mr Cakir says the conventional IMF response to concerns over exchange rate appreciation would be that the government should support the central bank’s monetary efforts by tightening fiscal policy. This is highly unlikely before an election, and Mr Ercel says the government does at least deserve credit for recognising the risks of a high current account deficit and advocating lower loan growth even in an election year.

However, each bank is understandably reluctant to curb its own lending growth, for fear that it will lose market share to competitors who choose to be unsportsmanlike. As one banker jokes: “Every bank is saying that we will grow by 35%, and someone else can grow by 15%.”

Both Mr Özince and Ziya Akkurt, the CEO of Akbank, argue that the 25% limit should be applied more rigorously to retail lending, and more loosely to corporate lending – since credit to companies that are export-oriented or import-substituting would help close the current account deficit.

Required reserves

There is also widespread condemnation of the central bank’s decision, taken in November 2010, to stop paying interest on the ever-increasing amount of required reserves that Turkish banks must place in the CBRT.

Mr Özince warns that this move will distort the market, because it heavily favours foreign-owned banks that can fund from their parents without incurring the reserve requirement.

In practice, however, most foreign-owned bank subsidiaries are still funding themselves locally, with loan-to-deposit ratios close to or lower than 100%. Jean-Paul Sabet, the head of BNP Paribas in Turkey and deputy chairman of TEB, of which the French bank now owns about 50%, says the approach to using BNP Paribas direct funding is cautious.

“We will use both sources of funding, but without excesses of any kind. Our business model is always to look for resilience rather than a short-term win, we are building something for the long-term, so we have to keep an equilibrium. But certainly parent funding helps,” he says.

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