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Orthodoxy welcomes carry traders in Turkey

coins, money, euro, erkan kilimci

A puzzle in economics is a situation where the implication of theory is inconsistent with observed economic data. Whether exchange rates are linked to observable macroeconomic fundamentals has long been controversial in the literature and there is early evidence against such a link dating back to the work of Meese and Rogoff (1983), leading to the so-called “disconnect puzzle”.

Speculation in Currency Markets: Carry Traders

Another well know puzzle is called the forward premium puzzle. The forward premium anomaly in currency markets refers to the well documented empirical finding that the domestic currency appreciates when domestic nominal interest rates exceed foreign interest rates. Uncovered interest rate parity (UIP) condition states that high interest rate currency (target currency) will tend to depreciate against low interest rate currency (funding currency) at a rate equal to the interest differential so that expected returns are equalised in a given currency.   Under UIP, any interest differential is offset by currency movements. 

Carry trade on currencies is known to be a speculative bet against UIP. A currency carry trade consists in selling funding currency to fund the purchase of a target currency or in selling forward a currency that is at a significant forward premium.

Carry trade strategy is especially popular when global financial markets are upbeat. The riskiness of these positions is disregarded during these periods as risk aversion is low and the search for yield wins over prudence. Ideally, you get paid for doing nothing. Initially carry trades weaken the funding currency, because investors sell the funding currency by converting it to target currencies. 

How to carry trade: FX Swaps

An FX swap agreement is a contract in which one party borrows one currency from, and simultaneously lends another to, the second party. Each party uses the repayment obligation to its counterparty as collateral and the amount of repayment is fixed at the FX forward rate as of the start of the contract. Thus, FX swaps can be viewed as FX risk-free collateralised borrowing/lending. The chart below illustrates the fund flows involved in a euro/US dollar swap as an example.

At the start of the contract, A borrows X·S USD from, and lends X EUR to, B, where S is the FX spot rate. When the contract expires, A returns X·F USD to B, and B returns X EUR to A, where F is the FX forward rate as of the start.


Turkey’s banking watchdog publishes weekly foreign exchange position of Turkish banks. Forward leg of foreign exchange transactions are reported as “off-balance sheet assets” of Turkish banks.

According to economists, foreign investor appetite for the Turkish Lira carry-trades has revived thanks to the return of the Central Bank to orthodox monetary policy, the relatively high interest rates, and the reversal of some regulatory steps. Turkish Lira appreciated by 8% in the last month.


One big problem with carry trades is that they become self-fulfilling. The carry trade is built gradually and initially seems to be very successful as the establishment of positions will tend to encourage the target currency to appreciate relative to the funding currency. However, the more of these positions that have been put in place, the greater the risk of a reversal when they are unwound. The unwinding is often dramatic as everyone tries to exit the trade at the same time.

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Broken monetary transmission: heterogeneity in funding markets

One of the mandates of modern central banks is to provide sufficient liquidity to the system as a result of being the lender of last resort. According to central bank law, the underlying objective is to eliminate any problems that may occur in electronic fund transfer system. Since central banks accepted setting short-term nominal interest rate as the appropriate instrument of monetary policy, the simplest system for controlling short-term interest rates is with a symmetric standing facilities corridor around the target rate. Open market operations are monetary policy operations conducted at the initiative of the central bank in order to achieve its operational target of monetary policy. Standing facilities are, in contrast to open market operations, monetary policy operations conducted at the initiative of banks.

Total amount of funding needed in the system is not an easy concept for ordinary economists who are not familiar with treasury operations. Some of them mix central bank funding with central bank reserves which is totally different in nature.

Monetary Policy Implementation, THEORY—PAST—PRESENT, Ulrich Bindseil

What causes the need for central bank funding ? Basically it is the business model of banking which is illiquid in nature. Banks give loans and collect deposits and try to make profit out of spread between the two. This spread is called net interest margin. Spread is justified with the maturity transformation function of the banks. At this point, central banks is mandated as the lender of last resort to safeguard the financial system’s liquidity.

What determines the amount needed for central bank funding? For most of the central banks, ‘autonomous factors’ explain the amount needed and main items are :
– cash in circulation
– net government balances
– net foreign assets
Under normal conditions, funding need of the system is expected to be equal to reserves of banks with the central bank.

Central Bank Turkey – Net Funding
From now on, we will make some calculations to analyze net funding and how it evolved in 2020. Turkish lira net funding balance (ticker: TP.APIFON3) is available at Data Central. As of October 2020, net funding increased by 216 Billion Turkish Liras.

Changes in net funding is related to the transactions that cause banks to lose Turkish Lira liquidity. At first place comes the foreign exchange transactions that cause increase in the need for central bank funding. Increase in derivative transactions of the central bank is also related to it.

FX Swap Liquidity
Turkish banks place foreign currency ( ticker: TP.DOVVARNC.K15) and gold (ticker: TP.DOVVARNC.K23) and receive Turkish Lira funding when they enter FX swap transaction with the central bank. Central bank publishes total outstanding fx swap balance at international reserves and foreign currency liquidity table which is prepared within the framework of the Special Data Dissemination Standards – SDDS – set by the International Monetary Fund (IMF). As of October 2020, fx/gold swap outstanding balance increased by 48.4 Billion USD which is equal to 393 Billion Turkish Liras with 8.12 TL per 1 USD. 

Transmission mechanism on monetary policy is the process through which monetary policy decisions affect the economy in general and the price level in particular. The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level.

Stylised illustration of the transmission mechanism from interest rates to prices

Heterogeneity and broken transmission channel
The role of the banking sector in the transmission of monetary policy has been studied in great detail in both the theoretical and empirical literature. If a bank’s characteristics are related to its ability to access non-deposit financing sources, then the existence of a lending channel implies that lending responses to monetary policy are related to bank characteristics.

There are three types of short term non-deposit financing sources reported by Turkish banks.

Billion TLPublic Banks Private Banks
Payables to Money Market 14312
Payables to Banks 7029
Funds From Repo Transactions 9348
TOTAL 30689

In 2020, public banks increased short term non-deposit financing balance by 276 Billion TL and private banks increased by 23 Billion TL. Although net funding need increased in 2020 causing tight liquidity conditions, public banks increased their lending and enjoyed short term cheap funding.




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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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The Cure or The Curse: Foreign Portfolio Investors

Narrative and perception outweigh reality in financial markets. The overstated role of foreign portfolio investors for the local currency bond markets is a good example. Turkey’s recent experience shows that lower yields are possible even without active participation of foreign portfolio investors. On the contrary, benefits of portfolio inflows may well exceed the costs during adverse developments. Such as sharp outflow of the foreign portfolio investments caused disruption in bond markets in 2013 and 2018 due to lack of sufficient market liquidity and one-way trading.

Foreign ownership in government debt securities is at its historical low. Since the trend is so obvious, it easier to analyze how yields reacted to this dramatic change.

Literature on the role of foreign portfolio investments in helping lower bond yields is vast and comprehensive. Obviously, bond investors earned the reputation to be smart money managers as well. So, interaction with bond investors is very valuable. This does not necessarily mean that without foreigners it is not possible to achieve lower yields.

There are two different regimes between 2017 – 2018 (1) and 2019- 2020 (2). In the first (1) period foreigners are more active in the bond markets and yields went up and in the second (2) period foreigners are less active and yield went down. It is observed that yields reflected macroeconomic developments as expected in all times. In the first period higher inflation expectations and higher short term rates priced in the higher yields, and in the second period lower inflation expectations and lower short term rates priced in lower yields.

So, economic policy makers should better focus on formulating the right decisions to fulfill their mandates. Consistent and transparent communication is important to manage expectations of all types of investors. It is the macroeconomic results that will attract long term investors at the end.

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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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Understanding the Demand and Supply in FX Markets

All prices are driven by expectations. Depending on the financial architecture, it is easier to analyze how expectations realized in the cash accounts of market participants. This kind of exercise is only possible in analyzing demand and supply in the cash foreign exchange markets. Otherwise derivatives volume in fx markets far exceed the cash volume.

Why do we need to analyze cash accounts? Basically, following the gold standard and several experiments on fixed exchange rates, it is common that name of the new financial order is floating exchange rates regime. On the other hand, this is not the case at all times. Especially fear of floating is very common in emerging markets. Given the side effects of disorderly movements in the exchange rates, it is inevitable for the analysts to detect the underlying cause of the movement and act accordingly. So, this kind of exercise to understand demand and supply conditions in cash markets is important.

In this exercise, we will try to calculate demand and supply for foreign currency in the last 12 months using Turkey’s balance of payments data and financial accounts. Here are the items that we will take into account:

– Current Account

– Debt Service

– Portfolio Flows

– Currency substitution & hedging

1) Exports, tourism revenues and imports are major components of balance of payments. Understanding the underlying trend in these items will also help us to project the future supply & demand conditions as well. 12 month sum of monthly current account deficit makes around 23 Billion USD. Deterioration in the current account balance is remarkable in the last 12 months. The impact of global pandemic on exports and tourism revenues mostly explain the widening gap in current account. On the other hand imports remain strong which need to be addressed with domestic financial conditions.

2) Literature of financial crises in emerging economies discuss the motivation and possible risks of foreign currency debt. Turkey accumulated foreign currency debt like other emerging economies. Deleveraging of the foreign currency debt is one of the channels for foreign currency demand. In this exercise we will use year on year change in Turkey’s net international investment position. Outstanding liability from international markets decreased by 5 Billion USD in the past year.

3) After the global financial crisis with quantitative easing policies, Turkey also enjoyed portfolio inflows into Turkish assets. This trend changed right after FED announced tapering in 2013. Portfolio outflows deepened during pandemic and outflows reached 20 Billion USD in the past 12 months. 

4) Currency substitution is just another term used for deposit dollarization. Given the open position of the corporate sector in Turkey, dollarization goes hand in hand with front loaded hedging. For the sake of simplicity we will use change in the outstanding foreign currency deposits in banks in Turkey. In the past 12 months foreign currency deposits increased by 31 Billion USD.

In this analysis, we summed up major items that are directly or indirectly related to demand and supply conditions in fx markets. Total net demand reached 80 billion USD in the past 12 months. This simplified calculation is in line with the change in the net position of the central bank international foreign exchange reserves.

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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.