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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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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.