Market Review 09.05.2024

Liquidity Panic is Unwarranted

The Central Bank Has Absolute Control Over the Turkish Lira

Since July 2023, the Central Bank of the Republic of Turkey (CBRT) has been gradually normalizing its monetary policy in line with economic theory, widely accepted market practices, and the requirements of central banking. It was a wise decision to initiate the normalization process gradually and in a controlled manner. Given the significant loss of the monetary transmission mechanism’s effectiveness, the disruption of the financial system’s functioning due to complex regulations, and the presence of elements that could pose systemic risks, such as dollarization, it was necessary for normalization to proceed with gradual and cautious steps. And that’s exactly what the Central Bank did.

Nearly a year has passed since the beginning of normalization, during which the policy rate was raised to 50%. CBRT’s overnight borrowing rate was set at 47%, and the lending rate at 53%. As a result, overnight interest rates in the money market formed symmetrically around the policy rate within a range of 300 basis points (bps). The rationalization of the decision-making mechanism and policy formulation was initially met with skepticism. Market participants found it difficult to believe that “normalization” in economic policy was permanent. However, as developments and outcomes turned into tangible results, doubts gradually faded away. Capital inflows began to be observed as an undeniable fact. Improvement in the Central Bank’s reserve position reached a level convincing even to the most pessimistic and skeptical. With the elimination of the possibility of a current account/foreign exchange crisis for a foreseeable period, dollarization/asset dollarization stopped, and the transition from foreign currency to the Turkish lira began. Both banks and the real sector became able to obtain financing from abroad under relatively favorable conditions. Positive reports from international investment institutions were supported by concrete rating upgrades from credit rating agencies. As a result, the risk premium in the market started to decrease.

We are pleased to note that the predictions highlighted and emphasized by Quanta Financial Advisory (Quanta) in its market comments and evaluations of the macroeconomic outlook since June 2023 have largely come true.

The increasing dollar purchases by the CBRT have led to an increase in TL liquidity in the money market. We expect the CBRT to continue its purchases in the face of ongoing capital inflows and domestic residents’ conversions from foreign currency to TL. Firstly, the CBRT needs to replenish the reserves depleted over the past five years as soon as market conditions permit. Additionally, if excess foreign exchange supply is not sterilized, the TL may temporarily enter a cycle of overvaluation, which is not desirable for financial stability. In short, the CBRT will sweep up the excess foreign exchange supply and clean up the market. This, in turn, means an increase in TL liquidity. At this point, it is observed that some commentators express concerns about the manageability of this liquidity pressure. However, unlike central banks that follow a strict fixed exchange rate regime, the CBRT, like any central bank, has full and absolute control over the currency it issues. Under the current monetary policy regime, the Central Bank can ensure that TL interest rates form wherever it desires in the money market. To put it more concretely, regardless of how large the liquidity surplus is, overnight interest rates in the domestic (onshore) market can never fall below the CBRT’s overnight borrowing rate.

Therefore, everyone can rest assured that, at least at this stage, dollar purchases do not pose a challenge for the CBRT in terms of TL liquidity management.

NOTE:

This issue was raised in 2010 when the CBRT made changes to its monetary policy framework in line with the conditions of the time. Mundell’s “Impossible Trinity” model, which can be summarized as stating that in an open economy with free capital movements, it is impossible for a central bank to simultaneously determine both the interest rate and the exchange rate, formed the basis of the criticisms at that time. However, this model is not symmetrical. In an open economy where the currency is not an international reserve currency and an independent monetary policy is pursued, the central bank indeed has limited power to prevent the domestic currency from depreciating against the foreign currency. But it can at least regulate the process of the domestic currency appreciating against foreign currency. Because it is possible for the central bank to sterilize all of the foreign exchange supply and withdraw the liquidity that entered the market at its determined interest rate. The only problem is that, due to the interest burden the central bank will bear, and the risk that this practice may disrupt expectations in the market if continued for too long, it is not an “impossibility” but rather a “difficulty” in the long run.

For those who want to read more detailed information on this issue:

Ibrahim Turhan, Yasin Akcelik & Orcan Cortuk. 2014. “Mitigating Turkey’s Trilemma Tradeoffs,” Emerging Markets Finance and Trade, Taylor & Francis Journals, vol. 50(6) November, pages 102-118. DOI: 10.1080/1540496X.2014.1013862