Fed and Turkey

Fed is trying to reduce its balance sheet. What will be the effects on Turkey?

Dunya Executive - - FRONT PAGE - by Sant Manukyan

1 What’s the importance of the Fed’s balance sheet size for emerging economies?

When interest rates were near zero, contrary to the common belief that the Fed didn’t “print money,” it provided reserves for financial institutions through a simple asset swap by buying bonds and mortgage-backed securities when yields were already very low. This made it possible to reduce long-term returns and for players to rearrange their portfolio structures. This raised the prices of risky assets, including those in emerging economies, improved balance sheets, eased lending and was perceived as a sign that the Fed would pursue a loose monetary policy for a while to come.

2 What does it mean when the Fed shrinks its balance sheet?

Reducing its balance sheet means the Fed is withdrawing the aforementioned reserves from the system. It will shrink the theoretical loan potential and mean the end of demand for fixed-income assets from an investor like the Fed, which owns one-third of the mortgage-backed securities market. All other variables are unchanged, but this development means i nterest rates will rise.

3 When will this happen?

Statements from the Fed’s board members indicate that it may start by the end of 2017 or in 2018. But the world’s biggest economy should certainly be growing to do that. 4 Is there a determined method for this move? No. The Fed won’t embrace a passive reduction and won’t guide assets due to reinvestment. The alternative is to actively sell assets in the market, but this option means the Fed is writing a loss and markets will deteriorate, resulting in new uncertainty. This is why this is unlikely to be the preferred course of action. The rate of reduction is clear with a passive reduction method, with a settlement date of the assets on the balance sheet. The most critical period for reducing the balance sheet to a total $780 billion appear to be 2018 and 2019.

5 What would be the pace and limit of this reduction?

We can speak of two limits. The first limit is economic conditions. In other words, a rapid increase in interest rates or an- other recession in the economy will end the reduction. The second limit is the natural level of the Fed’s balance sheet. If the growth rate of cash in circulation between 2000-2015 repeats itself in the next 15 years, the balance sheet will be on or even below the desired level by 2030. This means the Fed will never start its reduction until its pre-crisis level of $800 billion and it will end this reduction at a medium level.

6 Is it possible for the Fed to reduce its balance sheet and continue raising rates?

Technically, yes. What we understand from its statements is that the Fed will have a break for a while, but at a point both operations will be pursued simultaneously. The rate hikes didn’t significantly affect the long-term side of the yield curve but only carries up the short-term rates. If the Fed really feels discomfort with this action, it will move simultaneously and may want to move the curve as a whole.

7 How will it affect liquidity when the Fed permanently withdraws from the bond market?

Mortgage-backed securities especially will be negatively affected. However, the issue won’t be liquidity in either this market or U.S. bond markets. When the right prices are there – meaning when interest rates are at an attractive level – private-sector investors will step in.

8 Would it create a “taper tantrum?”

We’ve seen that the statement didn’t create such an effect and that markets have been relatively calm. However, the reaction will be more severe when the reduction begins in real terms. If it comes to that, it is also possible that the Fed can take measures, such as ending rate hikes or the reduction.

9 What does this decision mean for emerging economies and Turkish assets in particular?

The Fed’s withdrawal means new bond issues canalizing to the private sector and interest rates rising. The Fed may also have to pursue tightening faster than expected. Interest rates given to bank reserves being politically or socially unacceptable or an acceleration in inflation can force the Fed to reduce its balance sheet actively. This would raise the borrowing costs for emerging countries, appreciate the dollar faster than expected and thereby directly negatively affect companies or countries vulnerable to interest rates and the dollar rate.

10 In such a case, what should the Turkish Central Bank do?

A rise in the benchmark borrowing rate or an appreciation of the dollar - the simplest measures to reduce our costs – would help upgrade Turkey’s rating to the level of an investable country and reduce risk-related extra costs. Similarly, the expectation for a rise in long-term borrowing costs should result in long- and fixed-rate borrowings or the efficient utilization of swap markets. Certainly, the Central Bank may raise interest rates or use its reserves as a last resort, if there is a serious cash outflow.

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