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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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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.