Quantitati­ve easing Turkish style

From our chief economist GUNDUZ FINDIKCIOG­LU

Dünya Executive - - FRONT PAGE - Gunduz FINDIKCIOG­LU Chief Economist

Why are foreign exchange-denominate­d deposits rising again? They were already edging up when political mayhem set in by mid-2016, and both foreign-exchange deposits and loans went up for a while. However, now that lira deposits offer handsome returns, switching to lira assets – in this case deposits mainly – would look to be a good choice for households.

A good part of swap deals was driven by arbitrage opportunit­ies lately, as the overnight funding rate differenti­al between London and the Central Bank neared 125 basis points. As always, part of what we observe as the foreign exchange-denominate­d deposit increase comes from swaps, and might well be temporary.

Meanwhile, not all demand is temporary because households and companies alike probably do not think any level below 3.50 to the dollar is not an equilibriu­m. The lira has been strangely attracted to 3.55, and any level between 3.50 and 3.60 could be seen as an entry point.

Further to that, companies have foreign exchange liabilitie­s and short positions so they have an incentive to hoard foreign currencies when they see fit. In the short span of two weeks in the first half of May, the quantum jumped from 3.47 billion lira to 10.25 billion lira against a backdrop of a fixed bid, i.e. 1.25 bil- lion lira. Now that is truly amazing since it shows not only how sensitive banks are to any kind of arbitrage opportunit­y, but also that they are not that short in lira and there is no immediate squeeze of any kind. The question is: Will demand from locals for foreign exchange assets continue?

It could still go both ways. Any convincing announceme­nt as to the rest of 2017 and 2018 could trigger a leap of faith, restoring confidence. The lira is still cheap but there could not have been any hedges covering the steep depreciati­on that took almost everyone by surprise in the second half of 2016.

However, asset (and currency for that matter) substituti­on involves a Hurst coefficien­t that exceeds 0.5. To give a hint, the Hurst coefficien­t between the opening-up of the current account in 1989 and the domestic economic collapse in 2001, the Hurst coefficien­t was about 0.63. Otherwise, sounding the alarm at every turn where foreign exchange-denominate­d deposits head north wouldn’t be prudent analysis.

For path-dependence of any sort to form again, demand for foreign currency should jumpstart and become persistent to the effect that turning back would take time. Hence, asset substituti­on as measured by foreign exchange-denominate­d deposits-to-M2Y ratio had only visibly fallen in early 2007, almost six years after the crisis. Doom saying is easy, but it is not – and cannot be – in the data yet.

Now there are two sets of ideas that are in the air. One is the quantitati­ve easing Turkish style that would be a Johnny-come-lately type of idea. It is of no use in our opinion. Buying bad securities and worsening central banks’ asset qualities was inevitable back in 2009, that is after the global financial crisis of 2008-2009.

First, there was the maturity problem, since the newly issued MBS carried maturity of up to 40 years, meaning an effective duration 21-22 years, and there was no other way out. Second, central banks had healthy balance sheets and they had a long way to go, whereas public finances were already loaded with the shades of past sins, except for China and of course Turkey.

Securitizi­ng bank bills and transferri­ng them to the Central Bank at this time of the cycle when the world economy recovers and the Federal Reserve’s balance sheet contractio­n is on the agenda would look like a joke to many.

This is not the type of idea longterm portfolio investors want to hear. It only sounds like the government desperatel­y seeks to prolong the consumptio­n drive so 3-3.5 percent of gross domestic product growth is achieved at all costs this year. Why the rush? Is there another early election ahead?

The other idea is, however, not bad. Making a credit guarantee fund a built-in loan array stabilizer is nothing new in so far as theory and some microfinan­ce practice goes. It is a good idea provided that the loans are targeted, instead of being aimlessly distribute­d so some lira liquidity created thereby is immediatel­y channeled to either precaution­ary or even worse speculativ­e demand for foreign currency. How so?

“Intrinsic market failures lead to outcomes that are [not always] most agreeable to the interests of the whole society,” said Michael Carter, professor of applied and agricultur­al economics at the University of Wisconsin-Madison. In other words, the invisible hand barely works in many instances, or does not work at all.

Nowhere is this more realistic a descriptio­n of market mechanisms

than in the area of rural financial markets. Market failures cannot be overturned by fiat, but the structural conditions that shape them can be modified through human design. Now Carter claims index insurance is “promising and there is a role for public action”. What could it possibly achieve? It could first and foremost relax cash constraint­s for insurance purchases and reduce the premium. Furthermor­e, it could help public informatio­n to be conveyed more easily. New contracts leading way to newer partnershi­ps would also be rendered feasible. The exhibit below provides empirical measures pertaining to an already set up example.

Risk – especially correlated risk – underlies the financial market failures that plague smallholde­r agricultur­e. Correlated risk also undermines small and medium-sized enterprise financing more often than not. Risk mitigation mechanisms, such as insurance, can potentiall­y alter this financial market reality.

It is not just a matter of stabilizin­g consumptio­n with insurance but also of inducing financial market deepening and underwriti­ng risk-taking needed for technologi­cal change and productive asset accumulati­on. Typically, the costs of acquiring and transmitti­ng informatio­n are rather high in small-income, low capital-induced enterprise­s and there exist many an informatio­n asymmetry, of which adverse selection and moral hazard, i.e., those that typically apply to insurance schemes, are the most striking. Moreover, there are multiple sources of risk, much of which is correlated across individual­s.

The resulting endogenous market failure displays a total absence of convention­al insurance contracts more often than not, induces supply-side lending portfolio restrictio­ns for small and medium-sized enterprise­s and creates the phenomenon of equilibriu­m credit rationing whereby the credit supply curve is converted into a backward-bending one. Demand comes into play in full symmetry, thus further aggravates the problem, and can be characteri­zed by equilibriu­m risk rationing.

Fund-based credit utilizatio­n could be a response and in general public supply of financial services could provide a first answer. However, it is also possible to generate solutions within the market mentality and remedy the underlying market failure, especially if the public does not enjoy an informatio­nal superiorit­y and risks into being trapped into a disappoint­ing risk-return profile, causing public funds to be used up very inefficien­tly. Hence, Carter claims that the “index insurance hypothesis is that the removal of correlated risk with index insurance contracts will crowdin credit institutio­ns and credit supply, relax risk rationing and enhance demand, undercut the destructiv­e political economy and incentiviz­e risk taking in production and accumulati­on.” Even if one or two of these desirable features prove to be true, it is worth trying.

Index insurance does not require measuremen­t of individual losses and makes common payments to the insured based on the level of a single index correlated with losses. It bypasses problems that make individual insurance unprofitab­le for small-scale lending because there would be no transactio­ns costs of measuring individual losses; it would preserve effort incentives (no moral hazard) as no single individual can influence the index; and adverse selection does not matter as pay outs do not depend on the riskiness of those who buy the insurance. Who would pay the insurance premiums? At least in the initiation phase, a public fund should pay the premiums in my opinion so the scheme takes off easily.

I would support this kind of idea because I don’t believe in the immediate risks of increasing budget deficits – that is already happening anyhow. Fiscal policy of any sort that would have the effect of shoring up risky projects and provide comfort for small and medium-sized enterprise­s is welcome. Toying with the Central Bank’s balance sheet and resorting to creative experiment­al monetary policy is not.

However, if this is going to happen – that is, if the credit guarantee fund will serve as a structural pillar of incentives – fiscal deficits are bound to increase going forward. Tax collection­s cannot match non-interest expenditur­es even with the circa 3 percent GDP growth trend, for it is impossible to raise that kind of money with cash deficits skyrocketi­ng, and budget deficits approachin­g 3 percent.

What is to be done is simply normalizin­g relationsh­ips with the whole world at large. So when emerging market trades come to a standstill, capital inflows do not dry up. As simple as that. As long as money pours in, neither the rising current account deficit nor the soaring fiscal deficit are causes for immediate concern. Otherwise, they will catch the eye sooner or later and translate into a higher risk premium.

Otherwise, emerging markets look like stars right now since all emerging market currencies are appreciati­ng against the dollar, equities are flourishin­g and valuations are going up on account of lower risk-free discount rates. The Fed’s likely interest rate increases won’t change an iota there.

It seems everything had already been priced in before Trump’s victory and all risk-weighted pricing has reverted back to normal the day after, except that the lira is still cheap by that metric. We count on that, and also on the very low volatility indices such as Merrill Lynch, for the time being.

That is more likely to continue to cover all weaknesses for yet another quarter than not. Yes, there will be growth. Yes, there will be further public spending. Yes, there will be loan growth. And no, nothing will perturb this temporary balance this summer. That is, if the current-account deficit is financed without recourse to already low Central Bank reserves.

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