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

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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.

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Mission impossible for Turkish Lira

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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.

Deutsche Bank Foreign Exchange Research

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.

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From the impossible monetary trinity towards economic depression

The yield curve is a graph that plots the yield of various bonds against their term to maturity.

It has many uses:
– Setting the yield for all debt market instruments,
– Acting as an indicator of future yield levels,
– Measuring and comparing returns across the maturity spectrum,
– Indicating relative value between different bonds of similar maturity,
– Pricing interest rate derivative securities.

Yield curve takes different shapes. More formal mathematical descriptions of this relation are often called the term structure of interest rates.

Term Structure of Interest Rate (Definition, Theories) | Top 5 Types

There are various economic theories to explain the yield curve. Basically, the return on a long‐dated bond should be equivalent to rolling over a series of shorter‐dated bonds.  If we have a positively sloping yield curve, it means that the market expects spot interest rates to rise. Likewise, an inverted yield curve is an indication that spot rates are expected to fall.

Yield curve is important for policy makers but they neglect it until it forces itself on their attention. What they should know is that macroeconomic factors lead to changes in yield curve factors or vice versa. Economically, this kind of relationship is a function mainly of the expected rate of inflation. If the market expects inflationary pressures in the future, the yield curve will be positively shaped, while if inflation expectations are inclined towards disinflation, then the yield curve will be negative. 
High downward‐sloping curve is taken to mean that tight credit conditions will result in falling inflation.

Inverted yield curves have often preceded recessions. Empirically slope of the yield curve is related to the industrial production, output gap, capacity utilization rate and fiscal deficit.

Central Bank of Turkey economists also have shown that the slope factor is found to be correlated with the economic activity. The slope turns out to be negative during global financial crisis and in second half of 2016, which are marked by contracting economic activity in Turkey, while it rebounds in other periods.

Last time the yield curve was inverted deeply in 2018 August, industrial production slowed markedly until 2019 August.

Last week, Central Bank of Turkey increased the policy rate (one-week repo auction rate) from 10.25 percent to 15 percent, and decided to provide all funding through the main policy rate, which is the one-week repo auction rate. As the average cost of funding of the central bank was at 14.80 percent already, this modification has a meaning more than increasing short term interest rates by 20 basis points.

Yield curve tells us that economy policy makers of Turkey shifted from impossible monetary trinity policy making towards economic depression. This shift was unavoidable but it is questionable whether new policy framework is sustainable given the underlying economic weakness.


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Limits to monetary sovereignty and the case of Turkish Lira

One of the topics that still requires close attention in the field of economics is the nature of money. Countries with their own currency and with their debt denominated in it, have the capacity to print money to avoid default. This is basically called monetary sovereignty. That’s also the basic explanation why we use government’s debt as the risk free rate in finance.

In practice, monetary sovereignty has its own limits. As Fitch Ratings explains it with examples of past defaults, results of avoiding default is the most costly option in some cases. Countries may prefer to default for political reasons.

Printing money is old fashioned way of exercising monetary sovereignty, today’s Central Banks are more innovative. Electronic fund transfer system is the new printing machine. Central Banks are mandated to “ensure smooth functioning of payment systems” as a lender of last resort.

Instead of M1 which only makes 8% of money supply, it is M3 that matters. Money is endogenous and banks create deposits when they lend. 

If fiat money is pure debt, has no intrinsic value and easy to create, is there a risk of losing monetary sovereignty?

Money is a social convention. One party accepts it as payment in the expectation that others will also do so. Some economists argue the role of central banks and governance of economy to maintain the monetary sovereignty.

When it comes to to Turkey, risk of defaulting on foreign currency liabilities draws the limit to the monetary sovereignty of Turkish Lira. I would like to emphasize here that Turkey never defaulted on its debt and this kind of risk is more hypothetical than reality.

Although floating fx regime is expected to play balancing role to mitigate such macroeconomic risk in the long run, carelessness of policy makers may cause economic agents to behave disorderly in the short run. In the past 12 months, some 80 Billion USD foreign currency demand cause Turkish Lira to lose value substantially.


Turkey has accumulated large piles of foreign currency debt in the last couple of decades. This causes problem of debt intolerance which require careful macroeconomic policies. So, Turkey needs to avoid another round of increased foreign currency demand. Two important factors contributing are domestic money creation and foreign currency risk premium.

Here are the two underlying trends that capture these two factors:
1) Turkish Lira credit growth rate
2) International Reserves

Annualised growth rates (Annualised rate of change) show the value that would be registered if the quarter-on-previous quarter or month-on-previous month rate of change were maintained for a full year. Since we have week-on-week data for bank credits, we will annualize 4 week average. Linear approximation requires to multiply weekly average by 52. In this example, outstanding Turkish Lira loan balance that is available on weekly basis (EVDS ticker: TP.BO.SBIL02) will be used.

One of the FX demand factors is external debt service and currency substitution. Government and corporates prefer not to roll over external foreign currency debt as markets charge higher foreign currency risk premium. Level of foreign currency liquidity is an important proxy to understand dynamics of foreign currency risk premium. Central Bank of Turkey publishes its foreign currency assets on a daily basis. In this example, foreign assets that is available on daily basis (EVDS ticker: TP.AB.A02) will be used.








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Keynesian Beauty Contest and Credit Risk

Ultimate objective of any economic policy framework should be achieving sustainable cost of borrowing for the overall economy. It is not because debt is good for the economies, but it is because economic agents are already indebted too much already. And I mean not only the government borrowing but private borrowing as well. How is it possible to reach this objective? Answer to that question is related to the basics of finance: risk free rate and expected return. Investors ask higher premium for higher risks. Risk premium is the expected excess return on a security or portfolio, where excess return is the difference between an actual return and that of a riskless security. That’s why I cover the relationship between macroeconomic policies and risk pricing in my lectures. Central bank balance sheet is one of the results of macroeconomic policies. So, I believe every financial analyst should have a good understanding of the basics of central bank balance sheet.

The very concept of the international foreign currency reserves is a good example of how a central bank plays a crucial role in risk pricing. What is international foreign currency reserves? To put it simply, foreign currency denominated liquid and safe assets held on the central bank balance sheet are reported as the international foreign currency reserves. It is important to note that foreign currency receivables from Turkish banks do not fall under the category of international. Gold stored in vaults of the central bank is a different story. Since there is no credit risk attached to gold, it is reported as part of international reserves. 

There is a cost of holding international foreign currency reserves. This cost is simply the difference of borrowing from international markets and investing in safe liquid international assets. As you may imagine, safe liquid international assets yield much less than the interest paid for country’s international debt. On the other hand, everybody knows that when it is needed, no international foreign currency reserves are sufficient. If this is a true statement, why do central banks bear such a cost?

There are 2 good explanations for this question. One of them is the liquidity risk associated with short term foreign currency debt. Other explanation is related to how investors perceive the soundness of macroeconomic policies. Let’s remember the analogy of Keynesian Beauty Contest: perceptions matter more than the reality in the financial world.

Scoring approach of the credit rating agencies to the external position is good example how foreign currency liquidity risk is measured. The latest Moody’s report on Turkey has a special chapter on this issue. Moody’s calculates two version of international reserves, gross and net foreign exchange reserves.

Net foreign reserves is calculated with netting out banks’ required reserves for lira and FX liabilities. It is unfortunate that not reserves are in negative territory which is no good.

While Moody’s take into account gold holdings of the central bank broadly, in their reports they make net reserve calculation particularly only for foreign currency reserves. I believe this method is used to be able to make cross country comparison. As mentioned in the beginning, this is a Keynesian Beauty Contest, so I will not discuss the problems of this calculation.

Do the credit market investors price similarly like Moodys picture it? A credit default swap is designed to transfer the credit exposure of fixed income products between two or more parties. 5 year sovereign CDS spreads are strongly correlated to sovereign ratings. As expected like other derivative markets, sovereign CDS is traded to discover price of the country credit risk.

This kind of relationship is visible also for Turkey’s net reserves and sovereign CDS spreads. Policy makers need to calibrate monetary and fiscal decisions in order to achieve lower risk premium in the long run.


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Endogenous Money

Understanding how balance sheets interact with each other in an economy requires to define the role of money. Basically, modern money is a creature of double sided accounting. Endogeneity of the money means that it is not supply-constrained, but it is demand led. In this sense, “endogenous” means “having an internal cause or origin.” Notion of endogenous money is different than the monetarist approach. Quantity theory of money and monetarism claim that the money supply is exogenous and under the “direct” control of central banks. In fact, central banks use policy rates and other policy instruments and hope that economy will slowdown.

Turkish Banker’s Association describes how loan creates deposit.

This relationship is obvious despite the large off balance sheet balance. operations of Turkish Banks.

From the central bank perspective, as a lender of last resort in Turkish Lira, it is inevitable to supply reserves to banks as the major payment system operator. Turkish banks enjoy the cheap and unlimited liquidity to continue their operations.

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Balance Sheet Approach

Understanding today’s financial system requires at least basic knowledge of accounting. It is a world of interconnected balance sheets. Nature of the government sector’s liability is different than the nature of private sector’s liability.


This kind of approach is called balance sheet approach. From the perspective of balance sheet approach, a financial crisis occurs when there is a plunge in demand for financial assets of one or more sectors.

Creditors may lose confidence

a) in a country’s ability to earn foreign exchange to service the external debt,
b) in the government’s ability to service its debt,
c) in the banking system’s ability to meet deposit outflows, or
d) in corporations’ ability to repay bank loans and other debt.