BBVA report backs central bank mechanism to mitigate Turkish foreign exchange volatility
ABBVA research report has broadly welcomed a new mechanism by the Central Bank of Turkey to mitigate the volatility of the Turkish lira that involves the bank auctioning foreign exchange (FX) hedging instruments to help corporates to manage their FX risk. However, the research company is calling for strong communication on the tool’s framework to increase its effectiveness.
The central bank action, announced by Deputy Governor Erkan Kilimci on Nov. 13, is an initial step in the bank’s long-term project on the real sector’s open FX position. The new tool, designed in the form of non-deliverable forwards (NDF), will provide hedging with forward payments settled in lira without impacting on official reserves – crucial as the lira has lost more than 15% of its value against the US dollar in the past year.
On Nov. 18, five days after its initial announcement, the central bank decided to launch Turkish lira-settled forward foreign exchange sale auctions. “The maximum total amount of foreign exchange sale position is planned to be $3 billion until end-2017,” the bank noted in a statement.
BBVA’s report believes the mechanism of the hedging instruments will be similar to the Bank of Mexico’s NDF program announced in February 2017, which helped to reduce a period of volatility in the Mexican peso. ‘‘Hence, we elaborate the main goal of the tool is to reduce the Turkish lira volatility by both enhancing liquidity and increasing financial depth in the currency market. This could be help- ful especially during turbulent market conditions with an intensified shock disassociated with economic fundamentals,’’ the report stated.
A similar tool was implemented by the Foreign Exchange Commission in Mexico, which saw an intervention program of up to $20bn in FX hedging instruments in the form of NDFs. When auctioning the instrument, the Bank of Mexico announced it would sell USD-MXN up to a pre-determined amount and with a specified date within a 12-month horizon. The BBVA’s report includes graphs to show that ‘‘after the announcement of NDFs in Mexico, the peso had a positive trend and its volatility decreased even though this was partially supported by a change in the mood of the markets on NAFTA negotiations.’’
The BBVA research report said the broad framework of the Central Bank of Turkey’s own NDF program constituted two main areas: ‘‘Banks allowed to participate in the Turkish lira currency market are allowed to bid for these securities and corporates can benefit from the new facility indirectly as banks may gain an interim position.’’.
According to the report by the BBVA Research Department, the program will work in a similar way to the Bank of Mexico program. The central bank would ‘‘be able to sell USD (and buy lira) to local financial institutions as the counterparty buy USD (and sell lira). At maturity, if the FX rate is above the price agreed at inception, the [central bank] would pay to the counterparty only the difference in lira for each dollar hedged. On the contrary, the [central bank] would receive a payment from the counterparty. Since, both transactions will be in lira, the international reserves will not be affected.’’
The report continues: “Probably, there could be an impact on the monetary base in terms of [TRY] liquidity but this can be sterilized through the traditional operations. Here, the crucial point would be restoring liquidity and enhancing players within the market in both directions especially during stressed market conditions when the corporates carry concerns and speculation on further depreciation of the lira.”
In addition to the NDF program, the central bank has developed a “Systemic Risk Data Tracking Model” to analyze and follow the corporates’ currency risk effectively. A law to improve the efficiency of corporates’ data collection was drafted and presented to Turkey’s Parliament. ‘‘As an initial step on the [central bank’s] long-term project on the real sector’s open FX position and efforts to provide stability in the currency market, we welcome the new facility but also think that good communication on the tool’s framework is needed to increase its effectiveness,’’ stated the report.
The report states that while the direct counterparty for the bank’s tool will be eligible banks, it will also have a positive and indirect impact on corporates. It explains this by stating that as of August 2017, the real sector had an open FX position of around $210 billion (25% of GDP), making them vulnerable to currency shocks. “In times of rapid depreciation of the lira, these dollar indebted corporates could apply to both spot and futures markets to cover their short positions in dollars,” the report stated. But it suggests that the demand for US dollars is thought to exceed corporates’ actual amount of debt repayments in times of distress. BBVA gave two reasons for this: “Some corporates would try to cover not only the interest payment but also the principal amount of their FX debt assuming further depreciation” and “Apart from hedging, they would also get into speculative trading to benefit from the high volatility in the market.”
The report suggests that these two effects ‘‘further pressure the lira and amplify the first round shock. As the lira depreciates sharply with market participants in the short position in dollars, the hedging costs for FX indebted corporates also rise rapidly.’’ That is why the BBVA report backs the new NDF tool, which it believes will help to correct a ‘‘self-fulfilling cycle.’’
The BBVA report concludes with the statement: “In Turkey, corporates tend to buy dollars as a natural hedging instrument when the lira carries depreciation pressures and increases the potential of self-fulfilling movements (these sharp movements in currency create a vicious cycle that brings further inflationary pressure through sizable exchange rate pass-through and affects expectations by altering pricing behavior).
“In this respect, the new tool may serve to increase the depth and liquidity of the currency market and help the economy management cope with corporates’ currency risk effectively without excessively relying on international reserve.”