Endogenous money, currency substitution and macroprudential measures
We are not afraid of anything as we enter 2018. We shouldn’t be worried about a ‘sudden stop’, now a relic of the past, unless monetary policy misaligns entirely. No, to be a bit cautious is just enough. Is monetary policy misaligned at all? A rate increase of a larger magnitude could have had the desired effect perhaps, or it could have fostered further hike expectations. It depends. Let’s look at this more closely.
Money is probably endogenous in Turkey. Endogenous money means that money is created not by fiat, but by the exigencies of the financial system. Once loans have been granted and deposits have increased so core liabilities match to a large degree core assets, central banks accommodate demand for central bank money so as to guarantee solvency and manage systemic liquidity. In Turkey, the system is bank-based, and banks have also rather substantial non-core liabilities. Both core and non-core liabilities create assets. Money responds to asset creation; causality runs from assets (loans) to monetary aggregates. This is one view, and the evidence seems to shore up this conjecture. Hence, the central bank can only control the interest rates but not the supply of reserves. In other words, the central bank can either control interest rates or the quantity of its liabilities. In that case, barring the impact of cross-border capital flows on the currency and bond markets, the central bank can in principle use its interest rate as an exogenous policy tool, but not its supply of money. There is also the view that the central bank may not fully accommodate reserves demanded by commercial banks. If there are liquidity constraints, banks could overcome such constraints imposed via liability management. The liquidity preference view is the third approach, which questions the demand-driven money supply approach. Because economic agents have different liquidity preferences about the amount of money they wish to hold, if the supply of deposits is insufficient to meet the demand for loans, individual preferences will change relative interest rates to fill the gap by increasing the supply of deposits and reducing the demand for loans. This hardly fits the Turkish case though, where deposits are almost always in short supply, and the game is not a stage game whereby banks compete for deposits at time t=1 and lend at time t=2 accordingly.
Now a central bank study conjectures that money is indeed endogenous, i.e. the CBRT is accommodative of the demand for money. My own back-of-the-envelope basic econometric exercises indeed suggest the flowing mechanism. Demand for credit Granger-causes supply of credit; supply of credit causes the demand for broad money; non-core liabilities finance the 1/5 addendum to loan (asset) demand and creation; the CBRT regulates the exchange rate and bond yields. Even development banks are behaving pro-cyclically. The upshot is, despite many claims to the contrary –the last of such conjectures is the ‘winter is coming’ thesis - except short spans of turmoil demand is the main determinant, credit being almost surely not in short supply, and central bank money being almost always accommodative. The clearer implications of this claim are twofold: (a) as the money base – and M2 and M3 - are almost always accommodative, currency (asset) substitution doesn’t easily pick up because money supply rises in tandem with both deposit and non-core liability increases as loans go up, so the ratio of residents FX deposits to the money supply gets automatically stabilized at least to a certain extent; (b) without the cross-border flows, FX-denominated corporate and bank debt, and the current account deficit, the TRY interest rate could effectively be used as a policy tool. The extent of such use depends on the need of the FX-debt to be rolled over, and on the tendential currency (asset) substitution phenomenon. Managing the second part is to some extent within the power of the central bank.
Except the standard argument to the effect that inflation should be rendered low and stable, there are many things a central bank can do to prevent any shift towards dollarization. Forced de-dollarization is generally short-lived and coun-
ter-productive. Financial instability is the most fearful consequence, bringing in disintermediation, informal lending and expatriation of local capital. The government has already announced that a complete ban of FX borrowing for 23,000 small companies with FX debt below USD 15 million is on its way. This is not forced de-dollarization per se, but it comes close to it. Had it been spread to larger firms and larger sums it would have been interpreted in this light. However, there are no limitations for such companies. Instead, they would be required to implement hedging strategies. However, the details on hedging have not been announced yet. Tying FX income to FX debt is also a good idea, and I don’t buy the argument that such restrictions will lead to capital flight. It is just a sound, reasonable macroprudential measure.
One way of doing this – to trigger de-dollarization - is to create a sizeable wedge between reserve requirement ratios of FX and local currency deposits. FX deposits can also be discouraged since the currency composition of deposits and loans have a close relationship; at least from time to time they converge to each other. This is already done because RRR for local currency deposits and FX deposits are different; FX deposits carry 250 basis points of disadvantage. Already there are measures in place. The CBRT has been trying to prolong the duration of non-core FX liabilities, for instance. I don’t think tightening net open positions is fruitful because the net banking short positions are not high anyway. Toying with the liquidity coverage ratio so as to plug in a disincentive for FX liabilities can also provide a feasible tool. Deposit insurance ratios can also be altered in the same spirit. Again, I am not sure whether extending central bank operations in FX derivatives is a good idea. That would directly place central banks as market plays along the same dimension as hedge funds. However, there are the recent example of Mexico, and it seems it can be done. Anyway, there are already measures taken in that direction. All in all, reducing FX volatility would require many factors, some of which are within the power of the CBRT. I am optimistic.
I believe these are measures taken in the right direction. As such, currency (asset) substitution has not yet taken an inverse course, but it has risen somewhat in the last few years. The real issue is debt dollarization, not asset substitution. This will help exogenize the TRY interest rate – partly of course, not fully - if we take the endogenous money supply argument seriously, which I think we should. Any reduction in debt –and subsequently and eventually, asset - dollarization would help greatly because the argument to the effect that both the US and the EU moves in the direction of tightening, although fully correct, requires still some time to go. The full impact will possibly be postponed until H2, even Q3 2018. How so?
I do think tightening in the US and in the Euro Zone is now a fact of life. However, I am not sure its impact is immanent, and expect yet again a smoothing effect. First, the Phillips curve argument is still inconclusive, and whether 2 percent inflation in the US is a really doable perspective is subject to discussion. Rather, 1.5 percent is in the cards. This still leaves around 30 basis points, a real interest rate ex ante, currently. The reason why US T-10 years never moved up in the same way depicted by the Fed in February 2013 calls for many explanations. Nevertheless, the fact remains the same: it would have already been over four percent if the Fed guidance prior to the ‘taper tantrum’ were correct. Well, it wasn’t and it isn’t. There is one reason for this. Inflation is well below what would have been predicted by any Phillips curve given that unemployment is actually below NAIRU. These are hard times, and old manners of predicting things through stylized facts don’t work out smoothly. So, you pump in “inside money”, you more than quadruple the Fed’s balance sheet, you talk about the ‘new neutral’, lots of ink spilled on the ‘zero lower bound’, still you don’t get the inflation you want. Graphics are telling in this respect: market expectations not only almost always overshoot realized inflation, they are behind the curve also. The average is one thing; the downside or upside error margins are another. Market surveys tend to believe 2 percent is an elusive target right now. Hence, markets have systematically missed the inflation target upside and, somewhat contradictorily, they think the Fed overestimates its likely inflation to come. Maybe the NAIRU is not so ‘natural’ at all, and estimating Phillips curves simply wouldn’t do the trick. The main take is the US inflation can come about at 50 basis points lower than estimated by the Fed, and the US Treasuries 10-years may not go north by as much as forecast at any point in the last 5 years. They will go up, but just by how much and how steep is the main issue here. I would opt for Q4 2018 to see which is which.
This leaves some room for monetary policy if indeed money supply is fully endogenous. And while monetary policy is accommodative, the degree of (weak) exogeneity of the rate of interest depends to a certain extent the share of non-core bank liabilities and debt (more than asset) dollarization. I am not a believer in the ‘sudden stop’ scenarios; I am not a believer of a hard-core ‘winter is coming’ scenario either. Political risks will dissipate because Turkey has a geo-specific weight, and historical gravity, no matter what. I think I see not an especially bright year, but there are both technical and fundamental factors that may step in in its favour.