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November 17, 2024November 17, 2024

Turkey’s Economy Towards 2025: A Roadmap Within the Neo-Keynesian Macroeconomic Framework

Implementing Stability and Growth Strategies under Mehmet Şimşek, Minister of Treasury and Finance

Mehmet Şimşek, as the Minister of Treasury and Finance, leads a team dedicated to implementing a Neo-Keynesian macroeconomic policy framework. This approach prioritizes achieving a delicate balance between price stability and financial stability while anchoring inflation expectations. By maintaining disciplined public finances and promoting an effective financial system, the team aims to ensure sustainable economic growth and stability. As Turkey navigates through complex economic conditions, the emphasis on prudent fiscal management, balanced foreign trade, and a well-functioning financial system will be key. These pillars not only support the domestic economy but also build investor confidence, positioning Turkey as a resilient player on the global stage.

A Roadmap for Price Stability

Under the leadership of Central Bank Governor Fatih Karahan, a comprehensive roadmap for price stability has been developed to combat inflation and ensure sustainable economic growth. This strategy focuses on the coordinated implementation of monetary and fiscal policies to achieve macroeconomic stability. Key elements include enhancing the effectiveness of the monetary policy transmission mechanism by using interest rate hikes and tighter financial conditions to reduce inflation expectations. The roadmap also anticipates a gradual increase in credit interest rates and a significant slowdown in selective lending to balance excess demand and alleviate inflationary pressures. Additionally, measures to increase foreign exchange liquidity and promote de-dollarization are being implemented to strengthen confidence in the Turkish Lira by reducing commercial and retail FX deposits. This balanced approach aims to anchor inflation expectations, maintain fiscal discipline, and establish an efficient financial system, paving the way for a more sustainable and predictable economic structure for Turkey.

Effective Monetary Policy Transmission for Economic Stability

The Central Bank’s monetary policy transmission mechanism plays a critical role in shaping economic conditions by influencing short-term interest rates and overall financial stability. By adjusting the policy rate, the Central Bank directly impacts the cost of borrowing and the attractiveness of saving, which in turn affects consumer spending, investment, and ultimately inflation. When the Central Bank raises policy rates, it signals a tighter monetary stance, leading to higher borrowing costs and encouraging savings over spending. This helps to curb excess demand and control inflationary pressures. Conversely, lowering policy rates makes borrowing cheaper and can stimulate economic activity. This mechanism ensures that monetary policy decisions effectively permeate through the economy, influencing a wide range of financial variables and helping to achieve key objectives such as price stability and sustainable growth.

Controlling Credit Growth for Economic Stability

In Turkey, an uncontrolled surge in credit growth can lead to significant challenges, including rising inflation and an expanding trade deficit. Rapid credit expansion often fuels consumer demand and import activity, putting upward pressure on prices and worsening the trade balance. Recognizing these risks, the Central Bank has recently implemented measures to slow down credit growth. Through tighter monetary policies and selective lending restrictions, the Central Bank has successfully curbed the pace of credit expansion, thereby mitigating inflationary pressures and contributing to a more balanced external trade position. These actions are crucial for maintaining economic stability and ensuring sustainable growth in the long term.

Supporting De-dollarization and Phasing Out FX-Protected Deposits

The implemented policies have played a crucial role in supporting the de-dollarization process and achieving significant progress in phasing out FX-protected deposits. By promoting confidence in the Turkish Lira and tightening monetary conditions, the Central Bank has encouraged both individuals and businesses to shift away from holding foreign currency deposits. This strategic shift not only reduces the economy’s vulnerability to exchange rate fluctuations but also strengthens the domestic financial system. The gradual reduction and eventual elimination of FX-protected deposits mark a critical milestone in this transition, aligning with the broader goal of enhancing monetary stability and reinforcing trust in the local currency.

Rising Foreign Investor Interest and Successful Reserve Accumulation

Foreign investor interest in Turkish assets has been on the rise, reflecting growing confidence in the country’s economic prospects and policy direction. This renewed interest is evident in increased foreign participation in both the Turkish equity and bond markets. Simultaneously, the Central Bank’s reserve accumulation strategy has been effective, as evidenced by the robust increase in gross reserves. This approach not only bolsters Turkey’s financial resilience but also enhances its ability to manage external shocks. Together, these developments signal a strengthening of Turkey’s economic position and its attractiveness as a destination for international investment.

Strengthened Reserves and Credible Policies Drive Down Country Risk Premium

The strengthening of reserves, combined with the credibility of implemented policies, has led to a notable improvement in Turkey’s country risk premium. This positive shift reflects increased investor confidence in the stability and sustainability of Turkey’s economic outlook. As a result, the cost of external borrowing has significantly declined, making it more affordable for the country to finance its external obligations. This improved risk profile not only enhances Turkey’s access to international capital markets but also supports long-term financial stability and economic resilience.

Achieving Real Exchange Rate Appreciation and Breaking the Depreciation Expectations

The implementation of policies aimed at achieving real exchange rate appreciation has effectively broken the prevailing expectations of continued depreciation of the Turkish Lira. This shift indicates a more balanced and sustainable exchange rate, boosting confidence in the local currency. Market forecasts now reflect an anticipated real appreciation of the TL, signaling that the currency’s value is expected to strengthen relative to its fundamentals. This development not only reduces inflationary pressures but also enhances the attractiveness of TL-denominated assets, contributing to a more stable and predictable financial environment.

Strengthened Credibility of Tight Monetary Policy Anchors Inflation Expectations

The Central Bank’s commitment to maintaining its interest rates until a lasting improvement in inflation expectations is observed and has reinforced the credibility of its tight monetary policy stance. This firm approach has successfully anchored inflation expectations, signaling to markets and investors that the Bank is resolute in its fight against inflation. As a result, a downward trend in inflation is now anticipated, reflecting the effectiveness of these measures in stabilizing the economic outlook and fostering a predictable environment for future growth.

Consistent Economic Policy Framework Paves the Way for 2025 Macroeconomic Stability

The economic policy framework established by the current administration has been consistently structured and is expected to be implemented without deviation through 2025. This steadfast approach underscores the commitment to achieving the targeted macroeconomic stability, with a focus on sustaining balanced growth, reducing inflation, and maintaining fiscal discipline. By adhering to this coherent strategy, the administration aims to meet its macroeconomic objectives and foster a stable and predictable economic environment, providing a solid foundation for long-term prosperity and resilience.

June 3, 2024June 3, 2024

What is happening 12 months after following Turkish style experimental macroeconomic policy?

Turkey’s experimental macroeconomic policies, often referred to as the “Turkish style,” have been under the global spotlight due to their unconventional nature and significant impacts. Let’s delve into the key elements of these policies and their consequences over the past year.

1. Negative Real Interest Rates: Speculation and Excessive Credit Growth

One of the most striking aspects of Turkey’s macroeconomic policy has been the maintenance of negative real interest rates. This policy aimed to stimulate economic activity by making borrowing cheaper. However, it led to several unintended consequences:

- Speculation: Low borrowing costs encouraged speculative investments, particularly in foreign currencies and real estate, rather than productive economic activities.

- Excessive Credit Growth: The availability of cheap credit fueled an unsustainable boom in lending, leading to a buildup of private sector debt and potential financial instability.

2. Erosion of Central Bank Credibility

The Central Bank of Turkey (CBRT) faced significant criticism for its inability to effectively manage inflation and maintain confidence in its monetary policy tools. Key issues included:

- Ineffective Monetary Tools: Repeated interest rate cuts and unorthodox measures failed to curb rising inflation, leading to a loss of confidence among investors and the public.

- Delayed Inflation Response: The CBRT’s reluctance to respond aggressively to mounting inflationary pressures further exacerbated the problem, resulting in a credibility crisis.

3. Currency-Protected Deposits: Public Cost and Uncontrolled TL Increase

In an attempt to stabilize the Turkish Lira, the government introduced Currency-Protected Deposits (Kur Korumalı Mevduat, KKM), which provided a safety net for individuals and firms against currency depreciation. This policy, however, had several drawbacks:

- Public Financial Burden: The cost of these guarantees was borne by the public sector, leading to increased fiscal strain.

- Uncontrolled TL Supply: Each depreciation of the Lira resulted in the Central Bank injecting more TL into the financial system, further amplifying liquidity and fueling inflation.

4. Exchange Rate Control: Reserve Loss and Borrowing Problems

The Turkish government’s efforts to control the exchange rate amidst uncontrolled TL supply created additional challenges:

- Reserve Depletion: Attempts to defend the Lira led to significant losses in foreign currency reserves, weakening the country’s financial stability.

- Borrowing Crisis: The depletion of reserves and increased reliance on foreign borrowing raised the cost of external debt and heightened the risk of a debt crisis.

Conclusion

The past 12 months of Turkey’s experimental macroeconomic policy have highlighted the complexities and risks of unorthodox approaches. While the intent was to stimulate growth and stabilize the economy, the outcomes have included increased speculation, financial instability, and a loss of confidence in monetary policy. As Turkey navigates these challenges, the lessons learned will be crucial for shaping future economic strategies.

July 30, 2022December 31, 2023

Why Investors Are Nervous: Fact Checking With Turkish Central Bank’s Balance Sheet Data

I am lecturing at universities on practical aspect of economic policy making rather than ideas and theories. One of the topics I cover is the central bank balance sheet. Turkish central bank’s balance sheet is one of the most transparent one can find. Inflation targeting regime reduced the importance of monetary aggregates to some extent. Under inflation targeting regime, monetary policy implementation means controlling short term interest rates. Having reached the zero lower bound, central banks of the advanced economies used balance sheets to continue expansionary monetary policy. These operations inflated the balance sheet of central banks and resulted in appreciation of the value of assets purchased. So, analysis on central bank balance sheet’s quantities have become very crucial to understand the mindset of policy makers and possible implications on markets.

Meanwhile, central banks of emerging markets also expanded their balance sheets via accumulating international reserves, thanks to favorable global liquidity conditions. Turkish central bank is also one of them. Having accumulated large amounts of foreign debt, Turkiye has become more vulnerable to common global factor. Recent developments in foreign currency position of Turkish central bank makes investors nervous as it is observed in higher hard currency borrowing costs. High frequency data suggests deteoriating foreign currency position is main driver behind the higher sovereign risk.

No Standards for Analytical Representation

Central bank balance sheet is a result of all transactions conducted by the central bank with the rest of the world. They are usually displayed in various publications: annual reports, weekly bulletins, daily summary tables. The format and the accounting practices for analytical representation are not homogenous which is to say international standards are absent.

There are three different versions of central bank analytical balance sheet on electronic data dissemination system. They are organized to provide summary representation of main balance sheet items. These versions have daily, weekly and monthly frequency.

One of the versions of balance sheet published is prepared as per the letter of intent dated 18.01.2002. This version of the balance sheet is a result of a document which describes the policies that Turkiye intended to implement in the context of its request for financial support from the IMF.

In this part, central bank balance sheet analysis will be conducted with respect to its relevance to the monetary policy. There will be categorization into three and sub components will be discussed according to the size of balance sheet items.

Repeat After Me: Central Bank Money is the Cause and Central Bank Liquidity is the Result

Let’s start with Central Bank money. The liabilities of the central bank like any other credit institution is a form of money. The economy requires central bank money because it is the ultimate means of payment, carrying no credit risk; and the banking system intermediates between the central bank and the rest of the economy in obtaining the required liquidity.

Central bank banknotes are easy to understand what central bank money looks like. Banknotes are liabilities of the central bank and whenever deposit holders of the banks demand for banknotes, it is satisfied. Turkish Lira bank notes are printed at a factory owned by the central bank. Since central bank is a joint stock company, this liability is no different than unsecured debt since banknotes are not securities.

Second largest item is banks deposits. Banks deposits are result of the central bank’s required reserves policy. This policy aims to provide reasonable assurance to deposit holders in case of a sudden deposit withdrawals and required by central bank law. Central bank continue to use required reserves as macro prudential policy as one of the main tools of financial stability.

Third largest item is the balance of treasury at the central bank. Central bank is the bank of the Treasury, tax collections and other incomes are transferred to the Treasury accounts at the central bank.

When there is an increase in demand for central bank money (tickers: TP.AB.N01, TP.AB.N21), central bank is the provider of it (tickers: TP.AB.N26 and Turkish Lira provided via offbalance sheet swap transactions ).Below is a simple illustration of how central bank money and liquidity interact with each other.

Deteoriating Foreign Currency Position

One of the jobs of the central bank is to manage foreign currency liquidity. Main principle in managing foreign currency liquidity is capital preservation. This principle also requires taking limited liquidity risk. Assets in the portfolio are expected to have solid funding liquidity. That would also mean that markets of those assets need to be liquid.

Most of the central banks of the emerging market economies construct a portfolio of assets that will give assurance to investors that short term liabilities will be met under extreme financial stress . There are ratios that are used to analyze the level of foreign currency liquidity. One of the famous adequacy ratio is the Guidotti–Greenspan rule. The Guidotti–Greenspan rule states that a country’s reserves should equal short-term external debt (one-year or less maturity), implying a ratio of reserves-to-short term debt of 1. IMF has a particular page that calculates reserve adequacy for countries. Reserves are discussed mostly in relation to external vulnerability of economy. Short term external debt (EVDS Ticker: TP_KALVADBG_K18) of Turkiye is around 180 Billion USD as of May 2022.

According to recent data (July 22) Turkish central bank has 101 Billion USD foreign assets and 103 Billion USD foreign liabilities on its balance sheet. This is a good picture excluding central bank’s off balance sheet position.

Central bank prepare monthly “The International Reserves and Foreign Currency Liquidity” table within the framework of the Special Data Dissemination Standards – SDDS – set by the International Monetary Fund (IMF). The monthly table disseminated by the CBRT covers detailed information on official foreign currency assets and predetermined short-term net drains on foreign currency assets (including residual maturity) and contingent short-term net drains on foreign currency assets. According to the report published for June 2022, Turkish central bank has 60 Billion USD short position recorded off the balance sheet as these transactions are mostly forward leg of currency swaps with local banks and other central banks. Moreover, %42 of central bank reserves are in the form of physical gold held in the country and in currencies (%18) not in SDR market which lack immediate liquidity.

As a result of adverse developments on foreign assets on the central bank’s balance sheet , external vulnerability ratios detariorate and liquidity risk increases. Credit default swap markets price Turkish sovereign credit risk almost three times more than peer emerging markets.

April 24, 2022December 31, 2023

Turkish economy in troubled waters with no land in sight

Global Monetary Conditions to Tighten

Global inflationary pressures have taken the central stage in recent months. Although at one point FED officials argued otherwise, according to New York FED economists US inflation is acknowledged to be a broad based phenomenon. Global commodity prices skyrocketed and show no sign of return in the near future. FED already started to communicate faster and bigger rate hikes. Policy normalization will include quantitative tightening. The Fed’s asset holdings — mostly Treasuries and mortgage bonds backed by government agencies — more than doubled during the pandemic, to about $8.9 trillion from $4.2 trillion. In the March meeting, the minutes of which were released in April, Fed officials discussed shrinking the balance sheet at a maximum monthly pace of $60 billion in Treasuries and $35 billion in mortgage-backed securities — in line with market expectations and nearly double the peak rate of $50 billion a month the last time the Fed trimmed its balance sheet from 2017 to 2019. When global monetary conditions tighten investors lose their appetite for risky assets.

Growth Rebalancing with Unsustainable Dynamics in Charge

Consumer confidence indicators provide an indication of future developments of households’ consumption and saving, based upon answers regarding their expected financial situation, their sentiment about the general economic situation, unemployment and capability of savings. Turkish consumer confidence indicator hovers at multi year lows. On the other hand exporters continue to enjoy favorable conditions. As a result rebalancing in growth continues. This rebalancing trajectory is threatened by unsustainable dynamics in charge: managed floating foreign currency regime and negative real rates in Turkey.

Negative real rate environment in Turkey is the main driver of new money demand under unachored inflation expectations. Market participants expect inflation to stay at elevated levels according to survey data. Annualized three month average inflation reached 100 percent which signals for worse to come.

Economic agents demand for new money if they expect higher inflation. According to Richard Cantillon, the beneficiaries from the expansion of the money supply are the first recipients of the new money. As new money is created by banks, those who have the best access to bank credit benefit the most. If real rates are in deep negative like Turkey, it is not a suprise to see huge money demand. Annualized four week Turkish lira loan growth will eventually destabilize an unstable economy.

How to Finance Current Account Deficit?

It is obvious in Turkey’s case that negative real rates and accelerated loan growth become a poisonous mix for the external balance. Domestic economic agents prefer to purchase foreign currency linked assets in a front loaded fashion amid uncertainty in global prices. Turkey finances current account deficit in 2 ways: first, absorbing banking system’s foreign currency liquidity and second, borrowing from international capital markets. Foreign debtors are not willing to accept Turkish risk despite high risk premium offered by the markets. Given the latest development in US, also it is going to be very costly to borrow from international markets under current macroeconomic policy framework. On the other hand Central Bank of Turkey already utilized 40 Billion USD from local banks in the form of swap arrangement. Recently, Central bank introduced foreign currency deposit guarantee scheme to continue financing current account deficit with banking system’s liquidity. In summer period,there will be some relief with income from tourism sector to current account, but Turkey needs to tackle with external balance at the soonest possible.

March 6, 2022December 31, 2023

Mission impossible for Turkish Lira

Many market players accept that exchange rate forecasting models are poor in performance. Even it is not easy to explain the exchange rate movements ex-post. Fundamental-based exchange rate models tend to perform poorly particularly over short-term periods. However they tend to work better over medium and especially longer-run horizons.

Exchange Rate Determination Playbook

Evidence suggests that for short term horizons, a random walk characterizes exchange rate movements better than most conventional fundamental based exchange rate models. FX market participants typically fall under into one of two camps:

i) Shorter-run technically oriented traders or

ii) Longer-run fundamental-based investors.

Below is an illustration of how currency might behave with respect to different factors.

Poisonous Policy Mix for Turkish Lira: Negative Real Policy Rates, Unlimited Endogenous Money, Exchange Rate Targeting

Having visited exchange rate determination playbook, it is obvious that short term exchange rate determinants are not favorable for Turkish Lira. International money flows slowed and investor sentiment turned negative. Turkish consumer price inflation reached 54 percent as of February and policy rate stands at 14 percent. Ex-post real interest rate is 40 percent. The momentum of inflationary pressures continue to build up given the recent spike in global commodity and energy prices. This also means that negative ex-post real interest rates will continue for an extended period. As it was observed in the past, Turkey’s credit risk priced in CDS markets increased following deteoriating macroeconomic fundamentals.

Negative real interest rate environment leads to front loaded money demand. New money is mostly related with traditional hedging assets demand which are mostly unproductive (like land, used cars). As a proxy of new money demand, Turkish Lira loan growth momentum which is calculated over annualized 4 week average recently hit 57 percent.

One of the important determinants of exchange rate is trade balance in the medium term. Although recent economic policy framework aims to achieve current account surplus and increase in international foreign exchange reserves, the outcome is totally different. Given the new money demand and unfavorable international political environment, trade deficit signals for worsening current account balance.

Turkey manages exchange rate as an anchor to help bring inflation rates down. In order to achieve exchange rate target new FX protected Turkish Lira deposit scheme is introduced. The government introduced the scheme to reverse dollarisation, support the lira and lengthen the tenor of lira deposit funding. Customers who switch will be compensated if the exchange-rate depreciation on their new holdings exceeds the interest rate, with the authorities covering the cost. FX-protected deposits were recorded as TL 520.14 billion in the week of February 25. In other words, potential foreign currency demand is appr. 37 Billion USD, thanks to unlimited and cost free government protection.

Although Central Bank of Turkey enjoys utilizing fx protected deposits to achieve stable exchange rate, short and long run determinants of the exchange rate suggest that Turkish Lira stabilization is mission impossible with huge risks building up.

November 28, 2021December 31, 2023

This Time It is Different: Turkey’s Negative Real Interest Rate Policy

Negative real interest rate policy is common in advanced economies. The idea behind negative real interest rate policy is to keep financial conditions loose enough to stimulate economic activity. Turkey re-implements negative real interest rate policy when inflationary pressures are building across the economy. The question is not if economic agents will ask for more money at lower cost but how will they use it?

What is Cantillon Effect?

The process of money creation is no more a secret. Banks create money whenever they make a loan. There is no physical or natural constraints on how much money is created.

A Cantillon effect is a change in relative prices resulting from a change in money supply, which was first described by 18th-century economist Richard Cantillon.

According to Richard Cantillon, the beneficiaries from the expansion of the money supply are the first recipients of the new money. As new money is created by banks, those who have the best access to bank credit benefit the most.

Inflation expectations in Turkey signal for high money demand if Richard Cantillon is correct in his assumptions.

Orthodox Monetary Transmission Mechanism Under Inflation Targeting Regime

Although there is no quantity constraint on money creation, economic agents shift their money demand reflecting their expectations in the price of money. Central banks manipulate short term interest rates to manage expectations on future price of the money. This is basically called monetary policy transmission.

Expectations of future official interest-rate changes affect medium and long-term interest rates. In particular, longer-term interest rates depend in part on market expectations about the future course of short-term rates.

Monetary policy can also guide economic agents’ expectations of future inflation and thus influence price developments. A central bank with a high degree of credibility firmly anchors expectations of price stability. In this case, economic agents do not have to increase their prices for fear of higher inflation or reduce them for fear of deflation.
Transmission mechanism of monetary policy

Stylised illustration of the transmission mechanism from interest rates to prices

During the global monetary policy normalization, Central Bank of Turkey followed positive real interest rate policy in line with inflation targeting regime play book until 2020. In 2020, Turkey implemented negative real interest rate policy which was halted after sharp depreciation in Turkish Lira.

Negative Real Rate Policy in Turkey

Once again Turkey will apply policy rates lower than inflation rate under new policy framework. According to the recent communication of the Central Bank, new policy framework will help the current account to give surplus and accumulation of international reserves.

The improvement in annualized current account is expected to continue in the rest of the year due to the strong upward trend in exports, and the strengthening of this trend is important for the price stability objective.
Briefing on 2021-IV Inflation Report

Negative real interest rates are expected to stimulate the corporate sector to produce more and overcome the supply side problems in the economy.

The tightness in monetary stance has started to have a higher than envisaged contractionary effect on commercial loans.
Press Release on Interest Rates (21 October 2021)

New Money Demand is On the Rise

Since the Central Bank implemented new policy framework, economic agents started to increase the demand for new money. I will use annualized Turkish Lira loan growth momentum as the proxy for new money demand. Annualization is an easy way of describing momentum. To annualize a number, multiply the shorter-term rate of return by the number of periods that make up one year. Below chart is a simple annualization of Turkish Lira loan growth rate. Calculation is based on 4 week average multiplied by 52.

As we know that monetary policy works with an overall lag of 12 to 24 months, or even longer. Outcomes of new policy framework will be more observable next year. At the moment markets priced these outcomes with higher inflation risk premium and higher cost of risk.

September 4, 2021June 3, 2024

The Curious Case of Central Bank Liquidity

dollar, money, president of the u s a, erkan kilimci

Monopoly is a multi-player economics-themed board game.In the game, monopoly money is theoretically unlimited; if the bank runs out of money it may issue as much as needed “by merely writing on any ordinary paper”. I will argue in this post that central bank liquidity is no different than monopoly money for the banks. Central bank liquidity only matters in transacting with the central bank.

Basically the liquidity needs of the banking system results from the minimum reserve requirements imposed on banks and from autonomous factors that are beyond the direct control of the central banks.

How FED Floods US Banks With Liquidity

FED’s presentation of factors affecting bank reserves is a good example to understand how central bank liquidity moves in the balance sheet.

As it is seen from the table above, FED discloses the details of how 8.4 Trillion USD is supplied and absorbed.

3 largest supply factors:
(1-2) US Treasuries & Mortgage Securities Held Outright: The amount of securities held by Federal Reserve Banks. This quantity is the cumulative result of permanent open market operations: outright purchases or sales of securities, conducted by the Federal Reserve.
(3) Paycheck Protection Program Liquidity Facility (PPPLF): The Paycheck Protection Program (PPP) is a $953-billion business loan program established by the United States federal government in 2020 through the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) to help certain businesses, self-employed workers, sole proprietors, certain nonprofit organizations, and tribal businesses continue paying their workers.

3 largest absorbing factors:
(1) Reserve Balances with Federal Reserve Banks: Reserve Balances with Federal Reserve Banks is the amount of money that depository institutions maintain in their accounts at their regional Federal Reserve Banks.
(2) Currency in circulation: Currency in circulation includes paper currency and coin held both by the public and in the vaults of depository institutions. The total includes Treasury estimates of coins outstanding and Treasury paper currency outstanding.
(3) Reverse repurchase agreements: Reverse repurchase agreements are transactions in which securities are sold to primary dealers or foreign central banks under an agreement to buy them back from the same party on a specified date at the same price plus interest.

Interest-Rate-Targeting Central Banks Supply Whatever Reserves Are Needed

Banks lend by simultaneously creating a loan asset and a deposit liability on their balance sheet. That is why it is called credit “creation”–credit is created literally out of thin air (or with the stroke of a keyboard). The loan is not created out of reserves. And the loan is not created out of deposits: Loans create deposits, not the other way around.

If bank lending increases and the associated increase in bank deposits leads, as it will, to a higher level of minimum required reserves, the central bank will naturally supply those reserves. Otherwise there will be a central bank-induced shortage of reserves, and the overnight interest rate will go up, meaning that the central bank will not be hitting its interest-rate target. Central banks, in normal times, cannot target an interest rate and independently restrict the amount of reserves they supply. That’s the reason why Central Bank of Turkey’s liquidity is needed by banks to meet obligations.

It was in 2018 (pg.7, Monetary and Exchange Rate Policy for 2018), the last time Central Bank of Turkey disclosed details of liquidity affecting factors. The funding need of the banking system is mainly determined by the following factors:
Changes in monetary base,
a) Changes in the volume of currency issued,
b) Changes in banks’ Turkish lira (TL) free deposits at the CBRT.
The CBRT’s Turkish lira transactions in the market,
a) FX purchase/sale transactions against TL,
b) FX deposits against TL deposits transactions,
c) Export rediscount credits,
d) Government domestic debt securities (GDDS) and lease certificate purchase/sale transactions,
e) Interest paid/earned, current expenditures.
The Undersecretariat of Treasury’s Turkish lira transactions in the market,
a) The difference between the redemption and issuance of GDDS and lease certificates (excluding
redemptions to the CBRT),
b) Primary surplus inflows,
c) Privatization and Savings Deposit Insurance Fund (SDIF)-related transfers and other public
transactions

Developments in Selected Factors Affecting Central Bank Funding

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The funding need of the banking system has risen to 320 Billion Turkish Lira from 290 Billion Turkish Lira in 2021. Change in money base caused (Emission + Bank Reserves) increase in the funding need of the system by 104 Billion Turkish Lira. Especially this increase comes from the change in reserve requirements obligations of the banks. After substantial loan growth in 2020, Central Bank implemented normalization measures to curb the loan growth.

Central Bank lends TL loans to exporters via the acceptance of FX bills for rediscount. Repayments are made in hard currency which is the main channel to to increase central bank reserves. In order to find how much Central Bank of Turkey supplied liquidity to Turkish Banks under export rediscount loan programme which is one of the latgest factors affecting liquidty, we need to make a simple calculation. Central Bank of Turkey publishes outstanding loan receivables to Turkish Banks which is appr. 162 Billion Turkish Lira. The change in outstanding balance is around 23 Billion Turkish Liras. Meanwhile banks repaid total of 9.1 Billion USD loans which corresponds to 73 Billion Turkish Lira as of July 2021. So, total of 99 Billion Turkish Liras supplied to the banking system under rediscount loan programme.

Rest of the changes are mainly coming from autonomous factors that are volatile in nature. Since Turkey needs to continue accumulating foreign currency reserves, underlying trend is supplying permanent Turkish Lira liquidity to the banking system in the long run. For today, liquidity deficit in the banking system is mostly related to the bank reserves held at the central bank.

July 19, 2021December 31, 2023

Warning Signs For Turkey as Outstanding Eurobond Duration Shortens

A Eurobond is a debt instrument that’s denominated in hard currency other than the home currency of the country or market in which it is issued. Access to international markets depends on the perceived credit risk, often measured by a country’s credit rating. An international rating of B- is generally considered the minimum for issuance in the international capital markets. Investors are driven by yields and, in the current low rate environment, have been accepting more credit risk, pricing in default risks. In addition, many investors actively or passively track market indices, or benchmark their investments against them; if a bond qualifies for inclusion in an index it can therefore generate some ‘automatic’ demand.

The key drivers to issue Eurobonds centered around the ease at which funds can be raised, the lack ofconditionality in their use, and the drive to signal financial strength.

Turkey in International Markets

Turkish Treasury has taken international borrowing very seriously and has been one of the biggest suppliers for years. Currently, Turkey has 85 Billion USD outstanding Eurobond.

Turkey continues to borrow from international markets. Latest Euro denominated 5 year Eurobond issuance of Turkish treasury in July 2021 was priced at 468 bps spread to Euro mid swaps. Interest spread has been between 200 bps to 800 bps in the last two decades.

Below is an example of a 30 year USD denominated bond which was issued in 2000 and will be due in 2030. This Eurobond is priced at +525 bps over US Treasury’s 2029 5,25% bond at the issuance.

Who Owns Eurobonds?

Countries that are not able to raise long term funds in its domestic currency from international markets issue hard currency bonds. One of the reasons to borrow from international markets is to attract foreign portfolio investors.

Recent developments in ownership of Eurobonds suggest otherwise recently. Turkish banks and citizens are also clients of high yielding Eurobonds. Eurobonds are good substitute of foreign currency deposits. As of May 2021, more than two third of Turkish foreign currency deposit holders have deposit balance above 100.000 USD in their bank accounts. In total, this means purchasing power of approximately 150 Billion USD. Turkish residents hold 42% of outstanding Turkish Eurobonds. Turkish banks hold 26 Billion USD amount of Eurobonds. Nonbank residents hold 11 Billion USD amount of Eurobonds. Eurobond ownership by Turkish bank and non bank residents almost doubled in the last 2 years.

Maturity Shortening as a Risk

The original sin hypothesis was first defined as a situation “in which the domestic currency cannot be used to borrow abroad or to borrow long term even domestically” by Barry Eichengreen and Ricardo Hausmann in 1999. Original sin has important consequences. Countries with original sin that have net foreign debt will have a currency mismatch on their national balance sheets. Movements in the real exchange rate will then have aggregate wealth effects. In addition to original sin, debt intolerance is another term that needs to be understood well. Debt intolerance is a term coined by Carmen Reinhart, Kenneth Rogoff and Miguel Savastano referring to the inability of emerging markets to manage levels of external debt that, under the same circumstances, would be manageable for developed countries, making a direct analogy to lactose-intolerant individuals. It is already a well documented fact that the maturity structure of emerging market debt issuances correlates with their domestic conditions. That is, emerging markets issue long-term debts more in tranquil times, and issue short-term debts more when they are near crisis. Long-term spread is generally higher than short-term spread and this difference increases as the country approaches crisis (Broner, Lorenzoni and Schumukler (2005)). The refinancing challenges are often ignored at the time of issuance, since refinancing takes place in the distant future.

Duration of external debt bond stock continue shortening as Turkish Treasury is not willing to pay high interest rate spreads. On the other hand there is a lack of appetite by foreign investors to lend Turkish Treasury. Turkish residents become the main investors of Turksh Eurobonds. Given the high level of Turkey’s short term external debt, shortening maturity of external bond stock is not favorable in the long run.

Interest Rate Spread as a Sovereign Risk Indicator

Historically some governments defaulted on their foreign currency debt. Default risk is priced in terms of interest rate spread. The interest rate spread between Eurobonds and U.S. treasury securities should reflect sovereign default risk.

Default on sovereign bonds is mostly observed at the times of crises. IMF defines crisis period as follows in one of research notes:

Sovereign spreads above 1,000 basis points. Crisis periods are counted as those weeks during which sovereign spreads as measured by JP Morgan’s Emerging Markets Bond Index (EMBI) exceed 1,000 basis points on at least five consecutive trading days. Temporarily lower spreads during periods of up to 150 trading days are disregarded to avoid splitting crises into several events.

Sovereign ratings below B2/B. Crisis start dates are defined as downward rating revisions to or below B2 (Moody’s) or B (Standard and Poor’s, Fitch), respectively. Crisis end dates are defined as upward rating revisions to above B2/B. If ratings by more than one rating agency are available, we use the lowest rating to make the event window as wide as possible.

Below is the historical development on interest rate spread between due 01/15/2030 Turkey USD Bond and 05/15/2030 US Bond. Although Turkish sovereign risk deteoriated after 2018, it is still far away from crisis mode. Turkey needs to tackle short term external debt problem in order to cheapen cost of external borrowing.

April 17, 2021September 4, 2021

Turkey needs to solve problem of short term external debt

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Policy makers wish to achieve sustainable cost of borrowing for the overall economy. This kind of policy objective could be achieved with a proper macroeconomic policy framework. Monetary policy, fiscal policy and financial system policy make the three pillars to achieve policy objectives.

Deterioration in Short Term External Debt

One of the vulnerability indicators followed by international creditors is the level of international foreign exchange reserves relative to the short term external debt. Turkey’s short term external debt (Ticker: TP.KALVADBG.K18) on a remaining maturity reached all time high as of end of February. Such an increase results in weaker vulnerability indicators.

Who is responsible?

Details of the statistics show that this deterioration was a result of increase in short term public sector debt. Increase in public sector debt even offseted the decrease in private sector debt. There are a lot of details regarding composition of the short term external debt which makes the picture to look better. Still most of the analysts simply use the headline figure in their calculations.

Where Turkey stands in the World?

Turkey is one of the most vulnerable economy in the world to the external shocks given the short term external debt. This position also explains why Turkey fails to maintain lower cost of international financing. Deteriorating short term external debt position continue to put pressure on Turkey’s external debt dynamics.

Government of Turkey’s payments in foreign currency (Ticker: TP.D1TOP) reached 30 Billion USD in the last 12 months including external debt service and other transfers.

Turkish economy’s current account deficit reached 40 Billion USD in the last 12 months.

It is obvious that Turkey is in the need of continuous foreign currency inflows and to roll over external debt. But this is only part of the story, Turkey also needs to extend the maturity structure of its external debt.

March 6, 2021March 7, 2021

A Tale of Two Inflations in Turkey: Import Prices and Food Prices

One of the favorite explanations for high inflation is exchange rate pass through. Central Bank of Turkey spares an important part in their investor presentation to this relationship.

Interestingly this relationship is very closely monitored by currency traders as well. Since Central Bank communicates with the markets from the perspective of exchange rate pass through, currency traders expect Central Bank to react depreciation of Turkish Lira at historical levels. This relationship of Central Bank with currency traders can be simply explained as: “scratch my back and I will scratch yours”. Central Bank gets rewarded by the economists as far as currency traders continue to make profit. But unfortunately this relationship is from the beginnning to the end very pragmatic. And it ends up when currency traders decide to unwind their position.

It is sometimes argued that increasing globalisation and openness to trade has exerted downward pressure on inflation in developed countries by, for example, reducing import prices. It is just the opposite what Turkey experiences. On the other hand food inflation is totally a different story. Food prices are composed of two groups: processed and unprocessed food products. Unprocessed food products are goods such as fruits, vegetables, meat and fish that are offered for household consumption without significant processing, whereas processed food products are sold after processing and completion of a value-added chain.

What makes food prices so rigid ?

The high degree of climate dependence in production, high number of intermediaries in the supply chain, uncertainties surrounding agricultural subsidies, concentration of agricultural production in certain geographic areas, fluctuations in external demand, price structure of export goods, consumption pattern.

In 2021, it looks like that we will observe lower inflation in the coming period, thanks to the real appreciation in Turkish lira and seasonal behaviour of food prices. As tight monetary conditions remain intact, this pattern will become more visible in inflation as well.

Likewise food price seasonality, short term money managers also have its own seasonality. Both of the factors have been supportive in efforts to manage inflationary forces so far. The question remains what will happen when conditions become unfavorable?