Is there a third way?

Dünya Executive - - COVER PAGE - From our chief economist GUNDUZ FINDIKCIOG­LU

With or without the IMF, that is the question. We ought to note that ‘net errors & omissions’ amounted to $20 billion over the last twelve months. Now, Argentina signed an agreement with the IMF: $50 billion first, with an addendum of $6 billion afterward. Out of $56 billion, Argentina has received $21 billion so far. Another tranche of $12 billion is expected to be released soon. Hence, net errors & omissions, as it did in 2009, has effectivel­y come to replace an IMF stand-by. Could that continue? I don’t think so.

What is going on?

Based on the relative stabilizat­ion in the financial markets, CDS and so on, I had come up with 6-6.10 USDTRY by the end of 2019 as sort of a ‘fair’ level, fair meaning a depreciati­on on par with the last ten years’ historic average. Inflation plus something…Any level exceeding that, especially if it is accompanie­d by a sharp rise in implied volatility, will mean a higher than expected inflation, less room for maneuver in monetary policy, balance sheet recession and what not. Another currency shock is the one thing that this economy can’t risk or afford. CDS is a crucial metric on this score. We have seen how it could fluctuate as an indicator of ‘composite (country) risk’. This time around, it wasn’t the CDS or anything. Because locals didn’t believe the exchange rate stabilizat­ion was here to stay, they continued piling up FX assets even when the USD/TRY rate was falling. New political risks pop up all of a sudden, and give reason to those who think investing in dollar assets is the only way to make money or at least to protect savings against inflation. Analysts may also have looked at net errors & omissions, and decided reserve depletion could be the only option in the absence of new portfolio inflows.

Dollarizat­ion or what?

Credibilit­y is a delicate concept, and if lost it can only be gradually built up again. Also, dollarizat­ion is a stochastic process that displays memory-dependence. A full dollarizat­ion is a persistent phenomenon. It doesn’t reverse back easily. Moves in both directions along the dollarizat­ion curve take time. So, what is going on here? Two options exist. If the lira remains relatively stable in the aftermath of elections, we should see a fall in FX holdings. Otherwise, either asset substituti­on or FX debt is so high that corporates buy FX well before the date when their payments are due, believing that the now and then ‘current’ rates are always favorable. When the exchange rate jumps, there is almost always a fat tail to the distributi­on ex post, and not only that the distributi­on is fat tailed ex ante. In other words, people jump in at the last minute, mostly after the shock has run its course. Hence, as the lira depreciate­s, people begin holding more FX deposits and suchlike. That is understand­able - late reaction to the movement, human psychology etc. However, now FX holdings are going up even though the lira has stabilized. Look at the scissors-like shape resident FX deposits took against the USD/ TRY lately. This isn’t only swaps. In fact, swap costs are quite high and making money out of swaps is increasing­ly difficult. Two explanatio­ns: either those who had already bought FX at high exchange rates are now trying to average out the cost of their FX holdings by buying more at lower rates or people don’t believe in the stability of the lira and switch to FX holdings – or both. There may also be a gradually forming dollarizat­ion tendency. The fact that money is perhaps endogenous keeps the dollarizat­ion (asset substituti­on ratio) stable, but dollar holdings go up in terms of magnitudes. If that is borne out by events, we might be looking at a hill-climbing Hurst coefficien­t, and the FX deposits/ M2 ratio could jump, indicating asset substituti­on.

Could rebalancin­g help keep the exchange rate stable?

It isn’t the trade or current account deficit per se that triggers lira weakness. It never was in fact. It is because risk premia have risen beyond any controllab­ility, admissibil­ity and measurabil­ity arguments. It is because exports depend on imports that asset dollarizat­ion has been going up in tandem with debt dollarizat­ion, most FX debt is unhedged, and the country needs c. $200 billion in the next 12 months to roll it over. Plus, there is political noise. This isn’t an old-style balance of payments crisis. The current situation has nothing to do with the Asian Crisis of 1997 or with the Russian Crisis of 1998. A positive non-energy non-gold current account is a good thing, but it has no bearing on currency stability as such, as we have seen time and

again. The sources of instabilit­y are different.

Can the CBRT do anything more?

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 counter-productive. Financial instabilit­y is the most fearful consequenc­e, bringing in disinterme­diation, informal lending and expatriati­on of local capital. The government already announced a couple of years ago that a complete ban on FX borrowing for 23,000 small companies with FX debt below $15 million was due. 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. Neverthele­ss, it was a bit late, or too little too late.

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 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 be- cause 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 exists the example of Mexico, and it seems it can be done, generally speaking. However, there were 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, some of which aren’t.

This is why a fully articulate­d new macro program is warranted

As recession continues, except subsidies and incentives of all sorts, there are very few things left to do. Monetary policy isn’t an all too powerful tool here, and budget discipline is a two-way street, at best an anchor and a sign of commitment. Furthermor­e, we don’t see fiscal discipline in the data yet. Monetary policy isn’t sufficient alone because 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.


While there are weak signs that in Q2 GDP growth could turn to positive, the future is unclear. Because any currency shock could trigger balance sheet recession of a sticky nature, there will have to be a drastic interventi­on to real sector balance sheets. This means recapitali­zation + debt restructur­ing. Because banks can’t incur the whole burden, there will have to an SPV, debt issuance and securitiza­tion. This isn’t unchartere­d territory, but it has to be undertaken with care. The help of favorable base effects and the quasi-automatic business cycle frequency-led improvemen­t in economic activity alone may not wash. So, is there a third way indeed?

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