Macroeconomy | NOTES FOR MY STUDENTS

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

accounting, report, credit card, erkan kilimci

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.

February 7, 2021March 7, 2021

Underlying Trends in Turkish Economy under new Economy Management

Recent macroeconomic regime shift in Turkey resulted in meaningful adjustment of risk pricing in the financial markets. Portfolio flows into money markets and capital markets considerably supported Turkish Lira assets. On the other hand, foreign currency demand has been moderated recently.

New orthodox policy framework regime will be able to control credit growth under the ongoing weakness in overall economic conditions, especially domestic demand . Recent underlying trend in Turkish lira credit momentum is strong enough to normalize abnormal loan growth during the first quarter of 2020.

New economic management highlights the fact that inflation is still far from the 5 percent target and tight monetary policy will be implemented until inflation is under control. This kind of communication is good to attract some attention. Cyclical nature of some items even will help to achieve some sort of price stability.

FX pass through is the principal factor that explains recent inflationary pressures. Ongoing real appreciation of Turkish Lira is underway and this will help the inflationary pressures to subside going forward. As far as the global risk appetite allows, it is possible to see Turkish Lira further strengthening in real terms. Most of the prices in financial markets are mean reverting. Even without intervention, prices revert to its long term averages. As expected Turkish lira managed to gain value from historical low levels. Fast money captured the opportunity to profit from interbank dealings with Turkish banks.

Consumer confidence increases with the appreciation of Turkish Lira. Firms unwind fx hedges and increase fx borrowings as a result of lower risk premium and central bank put to control foreign currency. As it has been observed in the previous episodes current account deficit increases even under tight financial conditions.

Fast money positioning and tight monetary policy are not a remedy to fundamental problems of Turkish economy. Although external vulnerabilities require moderate level of money creation, lack of liquidity will create its own problems.

December 6, 2020March 7, 2021

Orthodoxy welcomes carry traders in Turkey

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.

November 21, 2020November 29, 2021

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.