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THE “UNORTHODOX” MONETARY POLICY OF THE CENTRAL BANK OF THE REPUBLIC OF TURKEY: DOES IT WORK? Master Thesis BASAK BARCIN Supervised by Mr Evren Ors September 2012 1 BURSİYERE AİT BİLGİLER Ad / Soyad Referans Numarası BAŞAK BARÇIN Sözleşme Numarası Sektör (Kamu, Üniversite veya Özel Sektör) JM -148EN TR2009/0135.0202/054 ÜNİVERSİTE Bursiyerin Bağlı Olduğu Kurum / Birim / GALATASARAY ÜNİVERSİTESİ / İli EKONOMİ / İSTANBUL Bursiyerin Bağlı Olduğu Kurumdaki Ünvanı Öğrenim Gördüğü Dil ÖĞRENCİ İNGİLİZCE Çalışma Alanı (İlgili Müktesebat Başlığı. Örn: Çevre, Ulaştırma, vb.) E-posta (Birden fazla belirtilebilir.) FİNANSAL HİZMETLER [email protected] JEAN MONNET BURS PROGRAMI KAPSAMINDA ÖĞRENİM GÖRÜLEN PROGRAMA AİT BİLGİLER Öğrenim Görülen Akademik Yıl 2011 – 2012 (Örn: 2009 – 2010, 2010 – 2011) Üniversite HEC PARIS Ülke / Şehir FRANSA, PARİS Fakülte / Bölüm HEC PARIS / FİNANS BÖLÜMÜ Programın Adı MSc in Finance (Business Track) / Masters (Örn: LLM in European Law, Msc. in in International Finance Economics vb.) Programın Türü (MA, MSc, kısa süreli MSc araştırma programı, vs.) Programın Başlangıç / Bitiş Tarihleri 07/09/2011 – 31/08/2012 Öğrenim Süresi (ay) 12 ay “THE “UNORTHODOX” MONETARY Tez / Araştırma Çalışmasının Başlığı POLICY OF THE CENTRAL BANK OF 2 THE REPUBLIC OF TURKEY: DOES IT WORK? Danışmana / Baş Araştırmacıya Ait Bilgiler Ad / Soyad EVREN ORS E-posta [email protected] 3 INFORMATION ABOUT THE SCHOLAR Name / Surname Reference No. BASAK BARCIN Contract No. Sector (Public, University or Private Sector) Scholar’s Affiliation / Department / City JM – 148EN GALATASARAY UNIVERSITY / ECONOMICS / ISTANBUL STUDENT Language of Instruction ENGLISH E.g. Environment, Transportation, etc.) E-mail (More than one e-mail might be specified.) 02/054 UNIVERSITY Scholar’s Title Field of Study (Related Acquis Chapter. TR2009/0135.02 – FINANCIAL SERVICES basak [email protected] INFORMATION ABOUT THE EDUCATION PROGRAMME Academic Year 2011 - 2012 (e.g. 2009 – 2010, 2010 – 2011) University HEC PARIS Country / City FRANCE / PARIS Faculty / Department HEC PARIS / FINANCE DEPARTMENT Name of the Programme MSc in Finance (Business Track) / Masters (e.g. LLM in European Law, Msc. in in International Finance Economics vb.) Type of the Programme (MA, MSc, short MSc study, etc.) Start / End Dates of the Programme 07/09/2011 – 31/08/2012 Duration of Education (months) 12 MONTHS THE “UNORTHODOX” MONETARY Title of the Dissertation / Research Study POLICY OF THE CENTRAL BANK OF THE REPUBLIC OF TURKEY: 4 DOES IT WORK? Information about the Advisor / Principal Researcher Name / Surname EVREN ORS E-mail [email protected] 5 TEZ/ARAŞTIRMA RAPORU ONAY SAYFASI Başlığı THE “UNORTHODOX” MONETARY POLICY OF THE CENTRAL BANK OF THE REPUBLIC OF TURKEY: DOES IT WORK? olan ve BAŞAK BARÇIN tarafından sunulmuş olan tezi/araştırma raporunu inceledim ve kabul edilmeye değer buldum. 24/10/2012 [Tez danışmanının ya da baş araştırmacının Adı ve Soyadı] [İmza] Prof. Evren Ors HEC PARIS 6 THESIS/RESEARCH REPORT APPROVAL PAGE I have examined the dissertation/research report entitled THE “UNORTHODOX” MONETARY POLICY OF THE CENTRAL BANK OF THE REPUBLIC OF TURKEY: DOES IT WORK? presented by BASAK BARCIN and hereby certify that it is worthy of acceptance. 24/10/2012 [Name and Surname of the thesis advisor or principal researcher] [Signature] Prof. Evren Ors HEC PARIS 7 TABLE OF CONTENTS LIST OF ABBREVIATIONS ........................................................................................ 9 LIST OF FIGURES ...................................................................................................... 10 LIST OF TABLES ........................................................................................................ 10 ACKNOWLEDGEMENTS ......................................................................................... 11 ÖZET ............................................................................................................................. 12 ABSTRACT................................................................................................................... 13 INTRODUCTION ........................................................................................................ 14 1. CENTRAL BANKS AND MONETARY POLICY ............................................ 15 1.1. CENTRAL BANKS ........................................................................................... 16 1.1.1. Functions ...................................................................................................... 16 1.1.2. Objectives ..................................................................................................... 17 1.1.3. Central Bank Independence ......................................................................... 21 1.2. MONETARY POLICY ...................................................................................... 25 1.2.1. Goals of Monetary Policy ............................................................................ 25 1.2.2. Monetary Policy Tools ................................................................................. 29 1.2.3. The Conduct of Monetary Policy: Choosing and Using the Right Monetary Policy Instrument .................................................................................................... 31 1.2.4. Transmission of Monetary Policy through the Banking System .................. 34 2. MONETARY POLICY STRATEGIES OF THE CENTRAL BANK OF THE REPUBLIC OF TURKEY ........................................................................................... 37 2.1. MONETARY POLICY APPLICATION BETWEEN 1980 – 2010 .................. 37 2.2. THE UNORTHODOX MONETARY POLICY IN APPLICATION: 2010 PRESENT ................................................................................................................... 58 2.3. EFFECTS AND OUTCOMES OF THE UNORTHODOX MONETARY POLICY ...................................................................................................................... 68 3. EVALUATION OF THE CBRT’S UNORTHODOX MONETARY POLICY . 80 3.1. GLOBAL EVALUATİON OF THE POLİCY PERFORMANCE ....................................... 81 3.2. EMPİRİCAL RESEARCH: INTERVİEWS ................................................................... 85 3.3. CRİTİCAL ANALYSİS OF THE CBRT’S UNORTHODOX MONETARY POLİCY ......... 93 CONCLUSION ............................................................................................................. 98 BIBLIOGRAPHY ....................................................................................................... 100 8 LIST OF ABBREVIATIONS • • • • • • • • • • • • • • • BRSA: Banking Regulation and Supervision Agency CAD: Current Account Deficit CBRT: Central Bank of the Republic of Turkey ECB: European Central Bank EM: Emerging Markets Fed: US Federal Reserve FX: Foreign Exchange GDP: Gross Domestic Product GNP: Gross National Product MPC: Monetary Policy Committee MTP: Medium-term Program OMO: Open Market Operations R&D: Research and Development QE: Quantitative Easing TL: Turkish Lira 9 LIST OF FIGURES Figure 1: Weight of Central Bank Objectives in Central Bank Laws ................................................... 18 Figure 2: Monetary Policy Objectives of Central Banks ....................................................................... 19 Figure 3: Correlation Between Average Inflation and Central Bank Independence (Alesina and Summers, 1993, p155) .......................................................................................................................... 22 Figure 4: Correlation Between Average Real GNP growth and Central Bank Independence (Alesina and Summers, 1993, p156) ..................................................................................................... 23 Figure 5: 2002-2005 Inflation Targets and Realizations ....................................................................... 54 Figure 6: Capital Flows to Emerging Markets ...................................................................................... 57 Figure 7: Accumulated Foreign Flows to Turkish Equity & Debt Markets .......................................... 59 Figure 8: Current Account Balance ....................................................................................................... 60 Figure 9: Turkey’s CAD as a % of GDP ............................................................................................... 60 Figure 10: Policy Rates and TL Required Reserve Ratios .................................................................... 62 Figure 11: Main Sources of Current Account Deficit Finance .............................................................. 63 Figure 12: Interest Rates and CPI Expectations in Turkey ................................................................... 64 Figure 13: Transmission Mechanism of the Unorthodox Monetary Policy .......................................... 65 Figure 14: Market O/N & Policy Rates ................................................................................................. 66 Figure 15: Market Liquidity .................................................................................................................. 68 Figure 16: Total Loan Growth Rates .................................................................................................... 70 Figure 17: CBRT Reserves ................................................................................................................... 72 Figure 18: Contribution of Consumption in Growth ............................................................................. 75 Figure 19: Performance of TL & EM Currencies vs. USD since August 2011 .................................... 79 Figure 20: Credit Growth in Turkey ..................................................................................................... 80 Figure 21: Annual CAD Level of Turkey (mn USD) ........................................................................... 82 Figure 22: Funding of the CAD (mn USD) ........................................................................................... 83 Figure 23: Annual Inflation ................................................................................................................... 84 Figure 24: Inflation Expectations .......................................................................................................... 85 Figure 25: Reserve Requirements and Open Market Operations (OMO) (mn TL) ............................... 95 LIST OF TABLES Table 1: Macro-Economic Data for Turkey between 1980 and 1988 ................................................... 41 Table 2: Macro-Economic Data for Turkey between 1989 and 1994 ................................................... 44 Table 3: Macro-Economic Data for the 1995-1999 Period in Turkey ................................................... 48 Table 4: Macro-Economic Targets of Transition to Strong Economy Program and Realizations ........ 51 Table 5: Inflation and Growth Figures Realized Between 2005 and 2009 ............................................ 55 10 ACKNOWLEDGEMENTS I would like to thank my academic supervisor Mr Evren Ors for his guidance, support and encouragement during this research. I would specially like to thank the Jean Monnet Scholarship Programme, and also the Turkish Ministry for European Union Affairs for their exceptional support during my master’s education at HEC Paris. I would like to further thank Orhan Ozalp, Aybars Sezgen, Alper Topaloglu, Atagun Kilic and Edip Gedizlioglu for participating in the interviews and helping me in my research by providing fruitful resources and suggestions. 11 ÖZET Son bes yil icerisinde, konut finansman sistemindeki kriz ve Euro bolgesinde yasanan borc krizi butun dunyada merkez bankalarini fiyat istikrari kadar finansal istikrara odaklanmaya yoneltti. Merkez bankalari bu iki hedefi es zamanli basarmak icin yenilikci yontemler arayisina girdiler ve yeni para politikalarina ve araclarina yoneldiler, cunku geleneksel yontemler istenilen amaca ulasmakta yetersiz kaliyordu. Turkiye Cumhuriyeti Merkez Bankasi, kuresel ekonomik ve finansal krizlerin negatif etkilerini onlemek amaciyla, alisilmisin disinda bir para politikasi tasarlayan ve yururluge koyan ilk merkez bankalarindan biri olmustur. Bu cerceve dahilinde, Turkiye Cumhuriyeti Merkez Bankasi, bir yandan ana hedefi olan fiyat istikrarini saglarken, kredi arz ve buyumesini kisitlandirmayi ve cari islemler acigini saglikli seviyelere indirmeyi hedeflemistir. Bu cerceve dahilinde alinan onlemler arasinda, gecelik repolarla birlikte haftalik repolar, faiz koridoru ve munzam karsilik oranlari gibi, yenilikci para politikasi araclari bulunmaktadir. Bu tez, Turkiye Cumhuriyeti Merkez Bankasi’nin uygulamis oldugu alisilmisin disinda para politikasinin yururluge girmesinin altinda yatan sebepleri, nasil tasarlandigini ve uygulandigini, ve yururluge girdigi gunden gunumuze kadar olan performansini incelemektedir. 12 ABSTRACT The subprime mortgage crisis and the Eurozone debt crisis that took place during the last five years pushed central banks around the world to concentrate on financial stability along with price stability. Central bankers searched for innovative methods to achieve their dual objectives simultaneously, and shifted towards unconventional monetary policy mix and instruments since the traditional approaches proved insufficient in providing the desired outcome. The Central Bank of the Republic of Turkey (CBRT) is among the first institutions to design and implement an unconventional approach in order to limit the negative impacts of the global economic and financial crises. Within this unconventional framework, CBRT aimed to preserve financial stability through limiting the credit supply and growth, and bringing the current account deficit to healthier levels, whilst keeping price stability as its primary objective. The macroprudential measures within this framework composed of innovative policy tools such as weekly repos along with overnight repos, interest rate corridor and reserve requirement ratios. This paper examines the reasons underlying the CBRT’s unorthodox monetary policy mix, its design and operating scheme, and evaluates its performance since implementation until today. Keywords: Unorthodox Monetary Policy, Current Account Deficit, Credit Supply, Reserve Requirements, Interest Rate Corridor, Financial Stability, Macroprudential Measures 13 INTRODUCTION The global economic outlook has seen major changes in the last five years. Starting with the subprime mortgage crisis in the United States in 2007, intensified with the Eurozone debt crisis in late 2009, key advanced economies entered severe recessions, which consequently had a significant impact on emerging countries. Turkey was one of the affected countries since its economy is very much intertwined with Europe. Central banks, observing these negative developments in the global economy, started to intervene the economy and decreased interest rates to stir economic activity. Federal Reserve decreased its policy rate to 0% levels from 5.25%, European Central Bank decreased its key interest rate to 0.75% from 3.75%, while the Central Bank of the Republic of Turkey decreased its policy rate, between late 2008 and 2010, to 6.25% from 17.50%. However, these reductions in interest rates and further quantitative easing schemes did not provide the expected improvement; yet, it created a massive amount of capital inflows to emerging countries in search of higher yields. These massive amounts of foreign capital inflows were very dangerous for a country like Turkey, which had an important current account deficit problem (CAD being almost 8% of GDP) for the last 30 years. They would render the country vulnerable to external economic shocks since a sudden halt in these capital inflows would significantly affect the already delicate funding scheme of the current account deficit. These capital inflows would further cause a remarkable expansion in the credit supply and overheat the economy. Thus, to prevent the adverse effects of these capital inflows and keep them under control, CBRT designed a new, and “unorthodox”, monetary policy mix late 2010; while it remained determined to its primary objective of reducing inflation, it started to focus on financial stability at the same time, meaning that it implicitly adopted a dual mandate whose components are hard to reconcile. This paper will first explain the functions and objectives of a central bank and the monetary policy instruments in order to achieve these objectives. In the second chapter, monetary policy programs applied by the Central Bank of the Republic of Turkey since 1980 will be presented. Then, the reasons why the CBRT designed and implemented 14 this unorthodox monetary policy, its design and operating scheme will be explained. Last section of the second chapter will assess the effects of this unorthodox policy mix on other monetary policy tools and CBRT’s dual objectives of price stability and financial stability. In the final chapter, the performance of this unconventional monetary policy will be assessed, with the contribution of the interviews that are done with the treasury departments of major banks in Turkey and with the fixed income portfolio managers and the strategist of the second biggest asset management firm in Turkey, in order to understand what are market participants’ expectations. The thesis will conclude with a critical analysis concerning this unorthodox monetary policy, which will be followed by a conclusion. 1. CENTRAL BANKS AND MONETARY POLICY Central banks are the national authorities in charge of monetary policy. Their actions affect interest rates, the amount of credit, and the money supply, all of which have direct impacts on both the financial system and the overall economy (Mishkin, 2010, p.315). Central banks play a crucial role in maintaining the health of the financial system and the economy. Especially after the recent crises, their role has become even more significant and important. In order to fully understand and analyze the impacts of the central banks’ actions on the financial system and the economy, we need to first understand what are the objectives and functions of the central banks, the goals of monetary policy and the tools to implement these policies. We take a look at how these monetary policies are conducted and transmitted through the financial system, and further touch on central bank independence. Whilst doing this study, we will cover the Central Bank of the Republic of Turkey, together with the two major central banks in the world: the Fed (US Federal Reserve) and the European Central Bank (ECB). We will compare the structural differences and similarities between these banks to get a holistic view about how central banks function. 15 1.1. CENTRAL BANKS 1.1.1. Functions Central banks initially started out as the government’s bank and added various other functions throughout time. Today, a modern central bank not only manages the monetary policy, but also provides an array of services to commercial banks, serving as the bankers’ bank (Cecchetti, 2008, p.352). As a state’s bank, the central bank has a monopoly on the issuance of currency. It creates money: the central bank can control the availability of money and credit in a country’s economy. It is mostly achieved by adjusting short-term interest rates. This activity is what we refer to as monetary policy. Central banks use monetary policy to sustain economic growth and maintain low levels of inflation. For example, an expansionary monetary policy, through lower interest rates, raises both growth and inflation over the short run, while tighter or restrictive monetary policy reduces them1 (Cecchetti, 2008, p.352). As the bankers’ bank, the most important jobs of the central bank are; - to provide liquidity to banks during times of financial stress, - to manage the payments system, and - to oversee commercial banks and the financial system (Cecchetti, 2008, p.353). Other very important function of a central bank is its capacity to act as the “lender of last resort”. The central bank’s ability to create money means that it can make loans when no one else can, including during a crisis. To avoid any possible liquidity shortage, the central bank can lend reserves or currency to sound banks. The central bank makes the whole financial system more stable by ensuring that sound banks and financial institutions can continue to operate and by avoiding the spread of bank-runs when confidence in the banking system fails (Cecchetti, 2008, p.353). 1 Mechanics of monetary policy will be described in the later sections. www.tcmb.gov.tr 3 http://www.ecb.europa.eu/mopo/intro/objective/html/index.en.html 4 http://www.federalreserveeducation.org/about-‐the-‐fed/structure-‐and-‐functions/monetary-‐policy/ 2 16 It is also equally important to understand what a central bank does not do. First, a central bank may monitor and participate in fixed income markets, yet it does not control securities markets. Second, the central bank does not control the government’s budget. It serves the government in the same way that a commercial bank serves a business or an individual. The treasury or the finance ministry manages fiscal policy, and the central bank provides them a set of services that make such management possible (Cecchetti, 2008, p.355). Thus, we can recapitulate the functions of a modern central bank as follows: As the State’s Bank, - Controls the availability of money and credit through interest rate targets and open market operations. As the Bankers’ Bank, - Guarantees that sound banks can do business by lending to them, especially during crises. - Oversees financial institutions to ensure confidence in their soundness. - Could operate a payments system for interbank payments (Cecchetti, 2008, p. 355). 1.1.2. Objectives Today, there is an emerging trend towards specifying central banks’ objectives, rather than only assigning functions. However, numerous central bank functions are still not guided by legally stated objectives. The figure below shows that objectives related to monetary policy have a significant weight in central bank laws than the objectives related to other functions (BIS, 2009, p. 21). Accordingly, we can classify central banks’ objectives as follows; - Monetary policy objectives - Financial stability objectives - Payment system objectives. We will now analyze these objectives further in detail. 17 Figure 1: Weight of Central Bank Objectives in Central Bank Laws Monetary Policy Objectives: Price stability, defined as low and stable inflation, is viewed as the most important objective of monetary policy. Policymakers are now increasingly aware of the social and economic costs of inflation and concerned with maintaining a stable price level. Price stability is desirable because high inflation creates uncertainty in the economy, makes it difficult to plan for the future, which might lead to a lower economic growth (Mishkin, 2010, p. 315 -316). “Price stability is usually the dominant monetary policy objective specified in legislation. In most cases it is a singular objective or is superior to other macroeconomic objectives specified in the law (as is made clear, for example, in mandates such as those requiring central bank support for the government’s general economic policy without prejudice to the central banks’ primary price stability objective) (BIS, 2009, p. 21).” Many countries have indicated price stability as the primary goal for central banks, since it is crucial to the long-run health of the economy. Mandates that put the goal of price stability first and state that the other goals will follow if it is achieved are called 18 hierarchical mandates. They are the directives governing the behavior of the European Central Bank (ECB) and the Central Bank of Republic of Turkey (CBRT). In contrast, dual mandates try to achieve two co-equal objectives; for example, price stability and maximum employment for the Federal Reserve (Mishkin, 2010, p. 319 -320). We can observe, in the table below, that price stability is the dominant or one of the dominant legal objectives in 33 of the 45 central banks listed (BIS, 2009, p. 21). Figure 2: Monetary Policy Objectives of Central Banks 19 Financial stability objectives: Majority of central banks presume that they have a policy responsibility for financial stability. However, fewer than half of central bank statutes contain objectives related to financial stability, and, of 146 central banks, less than one fifth have an explicit objective for financial stability (BIS, 2009, p. 25). In cases where an objective is set for the wider financial stability function, importance should be paid to the language since it implies a more conditional degree of responsibility for outcomes. For example, in Turkey, central bank is being charged with “promoting” a safe, stable or sound financial system, whereas in the Eurosystem, “central bank’s responsibility for overall financial stability is even more broadly defined as “contributing to” financial stability or to the actions of another authority pursuing a financial stability objective (BIS, 2009, p. 26).” Financial stability is not an absolute objective and almost impossible to represent and measure quantitatively. Furthermore, trade-offs need to be considered. Potential incompatibility with other policy objectives might arise since “instruments that might influence financial stability have other primary roles: interest rates for monetary stability; financial regulation for market efficiency and institutional or microstability; and prudential supervision for institutional or microsoundness. Diverting such instruments from their primary purpose involves trade-offs, thus a further risk of unintended consequences (BIS, 2009, p. 26).” This was proven during the recent crises. Even though financial and monetary policy objectives may not contradict each other in the midst of a crisis, such a conflict may arise upon implementation of the exit strategy. “Early removal of stimulus could delay the resumption of normal market functioning; late removal could risk the take-off of inflation (BIS, 2009, p. 26).” Payment system objectives: This is an objective that is found very frequently in central bank law. Statements of this objective are usually very general, stating the central banks’ commitment to smooth operating, sound and efficient payment systems (BIS, 2009, p. 28). However, like the problem with the specification of a financial stability objective, there are trade-offs among objectives that need to be considered in this policy area, robustness versus efficiency being the major trade-off. For this reason, extra-statutory 20 statements are used to specify these objectives and their associated policy frameworks (BIS, 2009, p. 28). Furthermore, there is an ever-increasing variety and sophistication of global payment systems. Thus, central banks need to be adequately flexible to be able to respond to new challenges (BIS, 2003, p. 45). 1.1.3. Central Bank Independence In recent years, there has been a significant trend toward greater independence of central banks. However, the issue of central bank independence, whether it should be independent or if it is better off under the control of the parliament, has been a controversial topic throughout years. There are two main arguments for central bank independence. The strongest argument rests on the shortsightedness of politicians, where political (electoral) cycle would impart an inflationary bias to monetary policy. Political pressures should not influence central banks, because politicians, who are driven by short-run objectives to win the next election, have the tendency to opt for short-run solutions to problems, such as high unemployment and high interest rates, even if they have unfavorable long-run consequences. For this reason, they might likely overlook long-run objectives, such as promoting a stable price level (Mishkin, 2010, p.338). Furthermore, a central bank under political control might be forced to purchase government securities in order to facilitate financing of large budget deficits. An independent central bank would better resist this pressure from the politicians (Mishkin, 2010, p.338). Another important argument in favor of central bank independence is the possible incompetency of politicians on issues of great economic importance. This argument can be best exposed in terms of the principal-agent problem. We know that both central bank and politicians are agents of the public (principals), and yet they have the incentive to act in their own interest rather than in the interest of the public. However, the principal-agent problem is more significant for politicians than the central bankers. 21 Thus, if a central bank is separated from political pressures, it can implement policies that are politically unpopular, yet in the public interest (Mishkin, 2010, p.338). As with the case for central bank independence, there are also two main arguments against central bank independence. First one is the lack of accountability of central bank decisions. Some argue that it is undemocratic to have monetary policy decisions controlled by an elite group that is responsible to no one, since there is no sanction on central bankers if the central bank performs badly. Another argument is that central banks have not always been successful in using their freedoms, such as the failure of Fed as a lender of last resort during the Great Depression (Mishkin, 2010, p.339). Even though central bank independence still has not been proven as the ideal structure, there is an ever-increasing tendency towards more independent central banks throughout the world. Besides, positive correlation between central bank independence and inflation levels is proven by empirical evidence. We can see in the figure below that countries with more independent central banks have lower average inflation rates. Figure 3: Correlation Between Average Inflation and Central Bank Independence 22 Source: Alesina and Summers, 1993 However, as Alesina and Summers (1993) has shown in their findings, although monetary policy associated with central bank independence suggests lower level and variance of inflation, it does not necessarily result in large benefits or costs in terms of real macroeconomic performance. Figure 4: Correlation Between Average Real GNP growth and Central Bank Independence Source: Alesina and Summers, 1993 Another important point in central bank independence, that is cited by Blinder (1998), is the central bank’s independence from financial markets, together with political influence. Central bankers turn to financial markets for instant evaluation of its decisions. However, financial markets might be over speculative, or speculative bubbles might overshadow fundamental variables. For this reason, central bankers have to be more cautious and prudent, and not overlook the fundamentals (Blinder, 1998, p. 61). In order to overcome the lack of accountability of central banks, which might have disastrous consequences, a central bank needs to be open and transparent. It should 23 communicate what it is doing, why and what is expected by this decision. This would allow outsiders to evaluate the success or failure of the central bank’s decisions. Moreover, a more open and transparent central bank provides markets with more information regarding its view on fundamental factors guiding monetary policy. By making itself more predictable to markets, the central bank makes market reactions to monetary policy more predictable to itself, which would result in a better management of the economy (Blinder, 1998, p. 68 -72) Moreover, in order to further implement accountability, central banks should just have instrument independence, which is the ability of central banks to choose appropriate monetary policy instruments, but not goal independence, which is the ability to set the goals of monetary policy (Fischer, 1994, p. 217). Thus, monetary policy goals should be set by the parliament, which is appropriate in a democracy, and by rendering the central banks accountable to the parliament so that the efficiency of central banks in achieving these policy goals can be efficiently monitored (Mishkin, 2010, p. 340). Now, we shall look at the degree of independence of the three central banks that are subject to our study; the Federal Reserve, European Central Bank and the Central Bank of the Republic of Turkey. The Federal Reserve has both instrument and goal independence. It is also not influenced by political pressure since the members of the Board of Governors are appointed for a fourteen-year term. More importantly, Fed has an independent source of revenue, which gives the Fed a remarkable advantage compared to other governmental institutions. Yet, it can still be subject to Congress’ influence since its legislation is written by the Congress and can be amended any time. Fed is also subject to the influence of the president, either indirectly through the Congress, or through the appointment of the members of the Board of Governors, which is quite often since most governors don’t complete a full fourteen-year term (Mishkin, 2010, p. 324 - 326). European Central Bank is the most independent central bank in the world. Even though the Fed is very independent, the Maastricht Treaty makes the ECB the most independent central bank (Mishkin, 2010, p. 330). Since ECB is a product of a treaty that is agreed and signed by all countries of the European Union, it is very difficult to 24 change the legislation under which it operates. This fact renders ECB more independent than the Fed (Cecchetti, 2008, p.391). Its structure, in terms of independence, is very similar to the Fed. Like the Fed’s Board of Governors, the members of the Executive Board are elected for long terms (eight years) without the possibility of reappointment and the heads of National Central Banks must be appointed for at least a five-year term. ECB, like the Fed, has a budgetary independence and it is not allowed to take instructions from any government (Mishkin, 2010, p. 330). Central bank independence has been a very controversial topic in Turkey. During the 1980s and 1990s, the activities of the CBRT and the Treasury were vastly intertwined. The conduct of money and credit policies was a duty of both the Central Bank and the Treasury in their foundation law, which resulted in a conflict of interest (Gokbudak, 1996, p. 323). Under the law that has passed in 2001, CBRT has gained full independence in conducting its task and mandate.2 1.2. MONETARY POLICY 1.2.1. Goals of Monetary Policy Monetary policy set by central banks has five specific goals: 1. Low and stable inflation. 2. High and stable real growth, together with high employment. 3. Stable financial markets and institutions. 4. Stable interest rates. 5. A stable exchange rate. Instability in any of these – inflation, growth, the financial system, interest rates, or exchange rates – poses a systemic risk that individuals can’t diversify away. However, it is very hard to achieve all five of the central banks’ objectives simultaneously. For example, stable inflation may result in less stable growth, and stable interest rates may be inconsistent with all the other objectives. Since central bank’s main task is to improve general economic welfare by managing and reducing systemic risk, it is very important that a central bank prioritize the objectives and finds the right combination of tools (Cecchetti, 2008, p.356). 2 www.tcmb.gov.tr 25 Now, we should go further in detail with each objective. Low and stable inflation: Many central banks take the maintenance of price stability – that is, to eliminate inflation – as their primary objective. Prices are central to everything that happens in a market-based economy, because they provide the information individuals and firms need to ensure that resources are allocated to their most productive uses. Yet, inflation degrades the information content of prices. When all prices are rising together, it becomes very difficult to understand the underlying reason. If the economy is to run efficiently, we need to understand what causes the prices to rise. The higher the inflation is, the less predictable it gets, and the more systematic risk it creates (Cecchetti, 2008, p.357). Furthermore, high inflation results in low growth. In a hyperinflation situation, – when prices double every 2 to 3 months –, prices contain virtually no information, and people use all their energy just coping with the crisis, so growth drops down (Cecchetti, 2008, p.357). Most people agree that low inflation should be the primary objective of monetary policy since it is the basis for general economic prosperity. But, it is equally important to decide how low inflation should be. An inflation level close to zero might result in deflation – a drop in prices –, which makes it more difficult to repay debt, further increasing the default rate on loans, and affecting the health of banks. Second, if the inflation rate were zero, an employer wishing to cut labor costs would need to cut nominal wages, which is difficult to accomplish. With an acceptable level of inflation, the employer can leave the nominal wages as they are, and workers’ real wages will fall. Thus, from an employer’s point of view, a small amount of inflation makes labor markets work better (Cecchetti, 2008, p.358). High, stable real growth:, Central bankers aim to moderate business cycles and stabilize growth and employment by adjusting interest rates. The underlying idea is that there is a long- run sustainable level of production called potential output that depends on different inputs, such as technology, the size of the capital stock, and the number of people who can work. Growth in these inputs leads to growth in potential output – which we would call sustainable growth. Over the short run, output may deviate from 26 this potential level, and growth may diverge from its long-run sustainable rate. For example, during recessions, the economy slows down, incomes stagnate, and unemployment rises. Central bankers can moderate such declines by lowering interest rates (Cecchetti, 2008, p.359). Contrary to recessions, there are times when growth rises above long-run sustainable rates, and the economy overheats. These periods may be regarded as increased prosperity; yet, reduced spending, lower business investment, and layoffs follow them, since they don’t last forever. For this reason, a period of above-average growth has to be followed by a period of below-average growth. During such periods, central banks raise interest rates and keep the economy from operating at sustainable levels (Cecchetti, 2008, p.359). Therefore, we can say that, in the long run, stability leads to higher growth. The rationale behind is that unstable growth creates risk for which investors need to be compensated in the form of higher interest rates. When interest rates are high, businesses borrow less, resulting in fewer resources to invest and grow. In addition to aiming high, stable growth, keeping employment high is equally important for a central bank (Cecchetti, 2008, p.359). Financial system stability: A stable financial system is a necessity for an economy to operate efficiently for one simple reason: when the financial system collapses, so does the economic activity. If people lose faith in banks and financial markets, they will opt for low-risk alternatives, and intermediation will stop. Savers will not be willing to lend and borrowers will not be able to borrow (Cecchetti, 2008, p.360). The possibility of a severe disruption in the financial markets is a type of systematic risk, which cannot be diversified away individually. Thus, central banks must control this systematic risk, in order to make sure that the financial system remains in good working order. They need to ensure that the markets for stocks, bonds, and the like continue to operate smoothly and efficiently (Cecchetti, 2008, p.360). Interest-Rate and Exchange-Rate stability: Central bankers will tell try their best to keep interest rates and exchange rates from fluctuating too much, in order to eliminate abrupt changes. Yet, these goals are secondary to those of low inflation, stable growth, 27 and financial stability. It is because interest-rate stability and exchange-rate stability are means for achieving the ultimate goal of stabilizing the economy; they are not ends unto themselves (Cecchetti, 2008, p.360). It is very important to reduce interest volatility as much as possible because, first, interest-rate volatility makes output unstable. Second, it means higher risk – and a higher risk premium – on long-term bonds. Risk makes financial decisions more difficult, lowers productivity and renders the economy less efficient. Since central bankers control short-term interest rates, they can control this risk and stabilize the economy (Cecchetti, 2008, p.360 -361). Stabilizing exchange rates has the last priority among all central bank objectives. However, it depends on the economic structure of a country. Exchange rate stability is especially important for emerging, less developed, trade-oriented countries, where exports and imports are central to the structure of the economy, since the value of a country’s currency affects the cost of imports to domestic consumers and the cost of exports to foreign buyers. However, it is not a priority for the Federal Reserve and the European Central Bank (Cecchetti, 2008, p. 361). For the Federal Reserve, the objective of monetary policy is: “The goals of monetary policy are to promote maximum employment, stable prices and moderate long-term interest rates. By implementing effective monetary policy, the Fed can maintain stable prices, thereby supporting conditions for long-term economic growth and maximum employment.”3 For the European Central Bank, the objective of monetary policy is: “To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty on the Functioning of the European Union, Article 127 (1).”4 For the Central Bank of the Republic of Turkey, the objective of monetary policy is: “The primary objective of the Bank shall be to achieve and maintain price stability.”5 3 4 http://www.ecb.europa.eu/mopo/intro/objective/html/index.en.html http://www.federalreserveeducation.org/about-‐the-‐fed/structure-‐and-‐functions/monetary-‐policy/ 28 1.2.2. Monetary Policy Tools Central banks implement these monetary policy goals mentioned above through several monetary policy tools. There are three tools that have been used traditionally by central banks: 1. Open Market Operations: They are the central bank’s purchase and sale of securities in financial markets. It is the most important monetary policy tool, since it influences the level of bank reserves and interest rates. Although the main objective of open market operations has been to control short-term interest rates and the money supply, after the recent financial crisis, this tool has effectively been used to affect long-term interest rates and to support the flow of credit in the financial system (Hubbard, O’Brien, 2012, p. 446). Open market operations occur at the initiative of central banks, which control the total volume. These operations are flexible and precise; meaning that they can be used to any extent. For example, if the desired change in reserves or in the monetary base is small, this can be achieved through a small purchase or sale of securities. Moreover, open market operations are easily reversed, and they can be implemented quickly, without any administrative delays (Mishkin, 2010, p.383). 2. Discount Policy: It is the monetary policy tool that includes setting the discount rate and the terms of discount lending. Discount window is the facility by which central banks makes discount loans to banks, serving as the channel for meeting the liquidity needs of banks (Hubbard, O’Brien, 2012, p. 446). Discounting is an important monetary policy tool in preventing and coping with financial panics, putting an emphasis on central bank’s “lender of last resort” function, and a particularly effective way of providing reserves to the financial system during a crisis since reserves are directly channeled to the banks that are having liquidity problems (Mishkin, 2010, p.384 - 385). However, use of 5 http://www.tcmb.gov.tr/yeni/eng/ 29 discount loans are at banks’ discretion and thus, not completely controlled by central banks, which renders it an ancillary tool (Mishkin, 2010, p.389). 3. Reserve Requirements: This is the regulation that requires banks to hold a certain proportion of checkable deposits as vault cash or deposits at central banks (Hubbard, O’Brien, 2012, p. 446). Changes in the reserve requirement ratio affect the money supply, thus affecting the money supply by causing the money supply multiplier to change. A rise in reserve requirements not only reduces the amount of deposits that can be supported by a given level of the monetary base and decreases the money supply, but also results in an increase of the target interest rate. For this reason, changes in the reserve requirement ratios are usually accompanied with offsetting open market operations (Mishkin, 2010, p.389). We need to look at this tool further in detail in order to better understand the discussions in the following chapters concerning our main argument. Reserve requirements are no longer used as an effective tool of monetary policy. For example, Fed had the authority to change reserve requirement ratio since the 1930s, however it rarely exercises this power. The last change was made in April 1992, where the required reserve ratio was reduced from 12% to 10% (Hubbard, O’Brien, 2012, p. 450). Likewise, the European Central Bank does not effectively use it. The main underlying reason is that increasing the reserve requirement ratio might cause immediate liquidity problems for banks, which are far more sensitive to these changes than other banks. This is what makes the monetary policy applied by the Central Bank of the Republic of Turkey increasing. Even though it is a progressively renounced tool, it is one of the tools that caused a stir as a part of CBRT’s unorthodox monetary policy mix6. There are two new policy tools introduced by the Fed during the financial crisis that are connected with bank reserve accounts: 6 Discussions concerning the use of reserve requirement as an efficient monetary policy tool and how it is applied by the Central Bank of the Republic of Turkey will be further explained in the following chapter. 30 1. Interest on Reserve Balances: Fed started paying interest on banks’ required reserve and excess reserve deposits ın October 2008. This reduced the opportunity loss for banks on the required reserves and gave Fed a greater ability to influence banks’ reserve balances. By this means, Fed can potentially increase banks’ holdings of reserves, thus restraining banks’ ability to extend loans and increasing the money supply by raising this interest rate (Hubbard, O’Brien, 2012, p. 446). 2. Term Deposit Facility: After the crisis, in April 2010, Fed initiated this facility, which would offer banks the opportunity to purchase term deposits, which are similar to the certificates of deposit that banks offer to households and firms. This term deposit facility provided the Fed with another tool that would help them manage bank reserve holdings. The rationale behind is that the more funds banks place in term deposits, the less they will be able to expand loans and the money supply (Hubbard, O’Brien, 2012, p. 446 - 447). 1.2.3. The Conduct of Monetary Policy: Choosing and Using the Right Monetary Policy Instrument There are three monetary policy strategies, all of which has price stability as the main, long run goal of monetary policy. These strategies are: 1. Monetary Targeting: Within this strategy’s framework, the central bank announces that it will achieve a certain target value of the annual growth rate of a monetary aggregate. The central bank is then accountable for achieving this target. This accountability aspect of monetary targeting makes it advantageous. Since monetary aggregate figures are easily observable, monetary targets can send immediate signals to the financial markets and to the public about the stance of monetary policy, and can help fix inflation expectations and further lowering it. However, it all depends on a strong and reliable relationship between the goal variable (inflation or nominal income) and the targeted monetary aggregate. If this relationship is weak, it will not send proper signals, 31 thus jeopardizing the accountability of the central bank (Mishkin, 2010, p. 395 399). 2. Inflation Targeting: This strategy is best described by Aglietta and Mojon (2012) as follows: “An inflation targeting central bank announces a target level for inflation and engineers the monetary policy that would drive inflation near this level. The inflation target is either a point or a range that sets a low and positive level of inflation for a given consumer price index, and the horizons vary, across countries, from a couple of years to the business cycle or indefinite. This preannouncement helps anchor inflation expectations and provide a benchmark against which the central bank can be held accountable.” (The Oxford Handbook of Banking, 2012, p. 247) Inflation targeting strategy involves several elements: (a) public announcement of medium-term numerical targets for inflation; (b) an institutional commitment to price stability as the main, long term goal of monetary policy and a commitment to achieve the inflation target; (c) an information-inclusive approach where many variables (not only monetary aggregates) are involved in monetary policy decision making; (d) transparency of the monetary policy strategy provided by communicating the objectives of the monetary policymakers to public; and (e) accountability of the central bank in reaching its inflation objectives (Mishkin, 2010, p. 399 - 400). However, just like other strategies, there are advantages and disadvantages of this monetary policy strategy. It increases the accountability of the central bank, since it clearly communicates a target, and thus easily observable due to the clarity of the target. Moreover, unlike monetary targeting, it does not solely rely on the money – inflation relationship. However, since inflation levels are observed, then announced, and thus lagged for a certain period, it sends delayed signals about the achievement of the target, whereas in monetary policy, immediate signals are sent to public (Mishkin, 2010, p. 402 - 405). 32 3. Nominal Anchor: Main difference of this monetary policy strategy than the others is that, it involves an implicit nominal anchor rather than defining an explicit nominal anchor in order for the central bank to be able to control inflation in the long run. It adopts a forward-looking approach in which the central bank prudently monitors signs of future inflation by using information from various sources, reinforced by “periodic strikes” by monetary policy to avoid inflation (Mishkin, 2010, p. 405). As stated above as a disadvantage of the inflation targeting strategy, there are long lags concerning inflation. Moreover, once inflation gets momentum, it becomes much harder to control. Thus, it is vital to prevent inflation from getting started; meaning that, the monetary policy needs to be forward-looking and act much before inflationary pressures in the economy. Although this strategy compromises many advantages of the inflation targeting strategy and demonstrated a huge success in the US, its main difference is that it lacks transparency, which results in a needless volatility in financial markets and doubt by public regarding inflation and output. This creates a lack of accountability for central bank, which is not present with inflation targeting (Mishkin, 2010, p. 405 - 408). The latter strategy has been used by the Federal Reserve (Fed), significantly during former chairman Alan Greenspan’s term, and proven successful up until the financial crisis. However, even though his successor – current Fed chairman Ben Bernanke – is a strong advocate of inflation targeting, neither an explicit inflation targeting, nor a single guide to policy has been adopted by the Fed (Mishkin, 2010, p. 407). The European Central Bank (ECB) follows a hybrid strategy that combines some elements from both the monetary targeting strategy and the inflation targeting strategy. The monetary policy strategy that the ECB pursues has two main pillars: Monetary and credit aggregates are evaluated with regards to “their implications for future inflation and economic growth” and several economic variables are used to evaluate the future outlook of the economy. However, ECB’s strategy is considered imprecise because, 33 even though the ECB announces a “below, but close to 2%” goal for inflation, it does not explicitly commit to an inflation target, which reduces its accountability (Mishkin, 2010, p. 398). Central Bank of the Republic of Turkey (CBRT) has adopted the “inflation targeting regime” in 2002. Between the 2002–2005 period, implicit inflation targeting regime was applied. From 2005 onwards, in order to increase predictability of policy decisions, the Monetary Policy Committee started to announce its meeting dates in advance, which resulted in the explicit inflation-targeting regime that started to be implemented in 20067 1.2.4. Transmission of Monetary Policy through the Banking System Over the past few decades, the economy, especially the banking system, has gone through a remarkable transformation. These changes have also affected the means by how monetary policy is transmitted through the banking system. Although the conventional interest rate channel is still comprehensively used, the credit channel, compromised of the broad credit channel and bank lending, is also gaining widespread acceptance (The Oxford Handbook of Banking, 2012, p. 257). We will now analyze each of these channels to understand how monetary policy is transmitted through the banking system. 1. The traditional interest rate channel: This view concerns the liability side of banks’ balance sheets. It results from the reserve requirement constraints of banks. This transmission mechanism works in the following manner. When a central bank carries out open-market operations, sells securities, with the purpose of monetary policy tightening, banks face a decline in reserves. Hence, banks are forced, by the fractional reserve system, to reduce reservable deposits to be able to continue to meet the reserve requirement. This shock not only constrains banks’ behaviors, but also prompts households to decrease their reservable deposits holding level, thus results in interest rates on other deposits and non-deposit alternatives to rise. This upsurge in short-term interest rates is then transmitted to longer-term interest rates, which is consequently followed by 7 http://www.tcmb.gov.tr/yeni/eng/ 34 a decline in the aggregate demand (The Oxford Handbook of Banking, 2012, p. 259 - 260). 2. The broad credit channel: It is also known as the “balance sheet effect”, or “financial accelerator”. It suggests that an increase in interest rates, which results from a monetary policy tightening, deteriorates a firm’s health, both in terms of net income and net worth. Firm’s net income is affected in two ways: first, its interest costs rise and its revenues decline due to the economic slowdown that a tighter monetary policy initiated. Its net worth is also negatively affected due to the lower cash flows that are generated by the firm’s assets, who were subject to a discounting with the higher interest rate as a result of the tighter monetary policy. This deterioration in firm’s both net income and net worth increases the external finance premium, for all sources of external finance, that must be paid by the firm. This increase in the external finance premium for borrowers results in a decline in aggregate demand, in addition to the decline related to the interest rate channel (The Oxford Handbook of Banking, 2012, p. 260). 3. The bank lending channel: Although this transmission mechanism has been controversial and less used in the past, it has recently started to stir interest – especially after the financial crisis. Interest rates are at their lowest levels all around the world, being very close to the zero bound on nominal interest rates in the aftermath of the crisis. Central banks are now seeking alternative monetary police tools as the traditional interest rate policies are now becoming ineffective because of this zero lower bound. As we have experienced during the past few years, lending facilities have been widely used to increase financial institutions’ lending process, highlighting the importance of banks in overcoming a recession (The Oxford Handbook of Banking, 2012, p. 257 - 258). As we have seen above, decline in available bank reserves due to a tighter monetary policy obliges banks to create less reservable deposits. Banks must replace these losses with non-reservable liabilities, or diminish their asset 35 portfolio, such as loans or securities, to maintain a balance between total assets and the reduced volume of liabilities. This decrease in the availability of bank loans, in addition to the interest rate effect, further decelerates the aggregate demand. The bank lending channel is especially important for countries where firms are ‘bank dependent’, meaning that they have limited access to financial markets, since their activities might be restrained should the bank lending channel is impeded (The Oxford Handbook of Banking, 2012, p. 261). 36 2. MONETARY POLICY STRATEGIES OF THE CENTRAL BANK OF THE REPUBLIC OF TURKEY Since 1980, Central Bank of the Republic of Turkey has gone through not only various different monetary policy applications, but also its structure has evolved significantly until today. For this reason, it is essential to review and understand what has happened since 1980, which monetary policies were applied by the CBRT under which conditions, and the developments that has contributed to the creation of the legal and structural framework that the Central Bank of the Republic of Turkey operates under today. In this chapter, firstly, monetary policies applied by the CBRT between 1980 and 2010 will be covered. Then, the unorthodox monetary policy under question in this paper will be presented. Last section of this chapter will assess the effects and outcomes of this unorthodox monetary policy in terms of other policy tools and CBRT’s objectives. 2.1. MONETARY POLICY APPLICATION BETWEEN 1980 – 2010 In this section, monetary policies applied by the Central Bank of the Republic of Turkey until 2010 will be presented under four different periods. • Monetary Policy application between 1980 – 1988 At the beginning of 1980, Turkey had various economic problems, such as high inflation, oil and energy inadequacy, import bottlenecks due to the lack of foreign currency, low economic growth, inability to payback foreign debt and as a result, a full balance of payments crisis; and it needed fundamental reforms in order to solve these problems (Onder, 2005, p. 147). As a part of these reforms, Turkey liberalized foreign trade, adopted an export-oriented industrialism strategy, and took important steps in order to restructure and develop its financial markets. The January 24 Decisions, which were put into effect to solve the economic crisis in 1980, raised some policy changes that would have long-term impacts on the industrialization and growth process. The most important characteristics of these decisions were that the pricing process was completely determined by market powers and it brought forward the need to open the economy to foreign countries under the free market conditions (Serdengecti, 1999). 37 The stability program, which became effective on January 24, 1980 and started to being applied gradually starting from that day on, had two objectives; the first one was to decrease the inflation rate and to halt its growth in order to provide internal balance, and the second one was to decrease the balance of payment deficit and gradually eliminate it altogether in order to establish external balance (Aren, 2008, p. 200). This decision envisioned an interest rate policy where money supply and demand equilibrium would be maintained, money supply increase would be linked to general price levels, and such that would prevent a potential increase in prices and enable to make investments that are required for the development of the country and prevent price increases (Ocal et al., 1997, s. 309). Within this framework, targets such as decreasing inflation, achieving a fast-growth performance, transitioning to a flexible foreign exchange policy and devaluating the Turkish Lira significantly, increasing exports by providing opportunities to exporters like tax and cheap funding, adopting industrialization strategy, decreasing the budget deficit and taking the necessary measures to accelerate foreign capital inflow, which are the general targets that IMF suggests to all countries, were determined for Turkey as well (Kadioglu, 2006, s.14). The main objectives of the January 24, 1980 decisions can be listed as follows (Onder, 2005, p. 147-148): - Increase savings in the economy by decreasing consumption expenses, - In order to get inflation under control by applying a tight money and loan policy, eliminate the financing deficit of public sector over time and limit Treasury’s borrowing from CBRT, - Implement a realistic and achievable interest rate policy in order to increase the savings and to collect these savings within the banking system, - Establish the supply and demand equilibrium for funds by simultaneously expanding funds that are lent to banks and decreasing demand for credit through high interest policy, 38 - Incentivize private and foreign capital in order to eliminate the financing deficit and to reaccelerate investments in a way to increase employment, - Apply a realistic and flexible foreign exchange rate policy in order to rapidly increase exports, - Direct flow of funds to encouraged sectors. After 1980, the interest rates changed in favor of depositors. It enabled companies to issue bonds and meet their financing requirements in a more comprehensive way. However, increase in the cost of debt caused a reaction within the real sector (Ergin, 1993, p.255). As a result of these economic measures, the inflation rate, which was 105% in 1980, dropped down to 34% in 1981 and to 28% in 1982. In 1981, while the practice of determination of the foreign currency exchange rates on a daily basis was adopted, restrictions on the interest rates were lifted. Small devaluations that are not in excess of 5% were made until May 1, 1981. On May 1, 1981, daily determination of foreign exchange rate started and foreign exchange rate adjustments authority was taken from Ministry of Finance and passed on to the Central Bank. With these regulations, the flexible foreign exchange rate policy, which decreases the differences between domestic and foreign inflation rates, was put into practice. The flexible foreign exchange rate policy had positive effect in terms of the flow of overseas domestic workers’ foreign currencies into the country and the increase of export revenues (Orhan, Erdogan, 2008, p. 355). The decisions taken on and after January 24 caused the interest rates of banks to increase and exhilarated money markets immediately; but, as the required legislative assurances were not in place, after a while, these decisions dragged the country into a crisis known as the “Banker Disaster”. As a result of this, the large banks mutually agreed to prevent adequate increase of interest rates. Later in 1981, Capital Markets Board was established, and with the allowance of issuance of new financial instruments like saving certificates, a certain proportion of savings was included in the insurance scope and some part of the savings was given to Savings Deposit Institution (Eroglu, 39 2004, p. 59). Between 1983-1985, the Decree No. 30 liberalized the interest rates on bank loans, while the authority to determine interest rates on deposits was assigned to the Central Bank. During this period, short-term interest rates were generally kept above the longterm interest rates and monetary authorities tried to give the impression that the inflation rate would go down in the long run. Later on, reserve requirements and bank liquidity requirement rates were lowered and rate differences between term deposits and demand deposits were eliminated. With the Decree dated 1985 based on Banks Law 1983, obligations were introduced for banks to allocate precautionary reserve for their delayed collectables and to keep certain amount of reserves proportional to the amount of loans they granted. Interbank Money Market and Open Market Operations (hence, a secondary market for Government Debt Securities) were established in March 1986 and in February 1987, respectively (Eroglu, 2004, p. 59). As a result, a strict economic regime was applied during the first three years following January 24 decisions. Nevertheless, starting from 1983 and 1984, an increase in the monetary expansion trend emerged. This situation primarily stemmed from budget deficits. In response, Central Bank’s direct loans and hence money supply increased (Orhan, Erdogan, 2008, p. 356). In the mid 1980s and particularly in 1987, the year when the elections were held, easing in monetary and fiscal policies had increased and devaluation expectations started to rise. Therefore, a series of measures were taken on February 4, 1988. Within this framework, deposit interest rates were loosened again (however a ceiling limit was determined); the required reserve ratio was increased to 16%, bank’s liquidity requirement was increased to 27%; selling export foreign currencies to banks in six months became obligatory, export tax return was increased and import deposit rate was increased to 15%. However, these measures could not prevent the escape from Turkish Lira. Thus, the central bank intervened and injected 160 Million USD to the market on October 12, 1988 in order to prevent depreciation in the value of Turkish Lira. Moreover, interest rates on deposits were completely loosened, the required reserve 40 ratios applied to foreign currency deposit accounts and demand deposits were increased (Gunal, 2001, p.60). As mentioned previously, the primary objective of the monetary policy is to establish price stability. When we observe the data for the 1980-1988 period, the fact that the inflation rate which was 101.4% in 1980 increased to 73.7% in 1988 shows that these policies was unsuccessful in practice. Besides, it can be said that, except for export figures, no positive developments were experienced in other macroeconomic indicators, either. Table 1: Macro-Economic Data for Turkey between 1980 and 1988 1980 1981 1982 1983 1984 1985 1986 1987 1988 Growth (%)1 -2.80 4.80 3.10 4.20 7.10 4.30 6.80 9.80 1.50 Inflation (%)2 104.40 34.0 28.40 31.40 48.40 45.0 34.60 38.90 73.70 Money 50.40 38.70 40.40 34.60 33.10 43.30 45.00 49.30 48.60 1 USD (TL)4 91.04 134.95 188.60 285.60 446.97 579.71 759.68 1.023.44 1.816.65 Export Value 2.90 4.70 5.70 5.70 7.10 8.00 7.50 10.20 11.70 7.90 8.90 8.80 9.20 10.80 11.30 11.10 14.20 14.30 -5.00 -4.20 -3.10 -3.50 -3.60 -3.40 -3.60 -4.00 -2.70 Issuance Increase (%)3 (bn USD) Import Value (bn USD) Balance Trade of (bn USD) Source: www.tuik.gov.tr The most important reason underlying the failure to prevent the increase in money supply during the period of 1980-1988 was the budget deficit. Central bank printed money continuously in an attempt to cover the budget deficits, and these deficits were financed through domestic borrowing after 1984. 41 The liberalization process in the Turkish economy, which started in 1980, was completed by lifting the foreign exchange controls based on the Decree No. 32 that was released in August 1989 and through decontrolling capital movements. The capital inflow to Turkey, which had been increasing since mid-1980s, multiplied in the 1990s, the net capital inflow, which was 73 Million USD in 1984, amounted to 780 million USD in 1989. However, in parallel to global developments, the portion of short-term capital flows and portfolio investments entering Turkey during this period increased whereas the portion of direct investments declined. • Monetary Policy application between 1989 – 1994 1989 was a milestone for Turkish economy, which was a result of the following three important developments (Onder, 2005, p. 172): 1. A sudden increase occurred in wages, which had been suppressed during the September 12 governments and the first Özal government period. This had significantly contributed to the public deficit, which was already increasing. 2. Weight in financing of public deficit was shifted from Central Bank sources to domestic borrowing. Accordingly, to make domestic borrowing available, interest rates were increased. As a result, both debt burdens started to increase while the term structure became shorter. 3. Capital movements were decontrolled with the Decree No. 32. The first and the second developments are related to each other. That is, the increase of real wages contributed to the increase in public deficit. The important point here that needs attention is the relation between the increase in interest rates and the liberalization of capital movements. This relation is the underlying reason of the gap between interest rates and foreign exchange rate, the increase of short-term capital inflows to Turkey, the banks’ increasing their open positions, and in short the reason behind the crisis in the early 1994 (Onder, 2005, p. 172). Although the Central Bank applied a monetary policy in 1986, 1987 and 1988 and 42 determined monetary targets, they were not announced to the public. As a matter of fact, no monetary policy was in place in 1989 as the targets were exceeded. In 1990, CBRT pledged for the first time that it would announce its monetary program to the public in a clear manner, adopt an interim targeting strategy and stick to these program in its practices. This monetary program, which was a monetary target adopted by the German Central Bank in the past to “control the Central Bank Money”, was based on quantitative and numeric magnitudes related to four variables from the balance sheet of the Central Bank. These variables were - in order of importance – the Central Bank Money, Total Domestic Assets, Total Domestic Liabilities and the size of the Central Bank Balance Sheet (Kepenek, Yenturk, 2001, p.234). The fundamental objectives of the monetary program that was put into effect in 1990 were determined as follows (Karatas, 2000, p.137): • Central Bank balance sheet shall grow by 12-22%, • Total domestic liabilities of the Central Bank shall increase by 15-25%, • Total domestic assets of Central Bank shall expand by 6-16%, • Central Bank Money shall grow by 35-48%. When the results of the 1990 monetary program are assessed; it can be observed that total domestic assets and total domestic liabilities were in line with the targeted levels; however, size of the balance sheet exceeded the upper limit, and Central Bank Money was below the lower limit of the target corridor (Orhan, Erdogan, 2008, p. 367). The monetary program that the CBRT designed and applied in 1990 was a mediumterm program, and it covered the period between 1990-1994. This program was relatively successful; however, the developments that emerged in the Turkish economy in the following years did not allow the new monetary programs to be feasible and put in use. Thus, because of the severe problems that Gulf Crisis caused as well as the government change in the second half, and further uncertainty caused by elections, a monetary program was not announced for 1991 (Ocal et al., 1997, s. 314). 43 In 1992, CBRT tried to prevent the extreme fluctuations in the foreign exchange rates. In order to prevent the increasing liquidity pressures in foreign exchange market, Central Bank withdrew the excess liquidity through open market operations. It intervened the foreign exchange market through selling foreign currency. Open market operations increased the liabilities of the Central Bank. The Central Bank Money, which was included in the monetary program, reached levels way above the target (Karatas, 2000, p.139) Consequently, it was understood that the monetary programs applied were unlikely to prove successful as long as the monetary policy instruments were significantly influenced by fluctuations in the foreign exchange market due to the external financial liberalization and inability to control public sector deficits. At that point, CBRT acknowledged the need for implementation of an effective fiscal policy in addition to monetary policy (Ocal et al., 1997, s. 314). As a result, the monetary policy that was applied between the 1991 – 1993 period was unsuccessful. Since Central Bank’s nominal anchor was completely indexed to the public financing requirements; it lacked the flexibility to signal to other sectors. Moreover, the excessive and irresponsible use of election economy during this period and the use of Central Bank sources for this purpose further aggravated the crisis conditions (Oktar, 2001, p. 94). Table 2: Macro-Economic Data for Turkey between 1989 and 1994 1989 1990 1991 1992 1993 1994 Growth (%)1 1.6 9.4 0.3 6.4 8.1 -6.1 Inflation (%)2 63.3 60.3 66.00 70.1 66.1 106.3 Money 86.5 68.2 51.3 73.0 71.3 90.5 1 USD (TL)4 2.316.0 2.933.0 5.085.0 8.573.0 14.487.0 38.495.0 Export Value 11.6 12.9 13.5 14.7 15.3 18.1 Issuance Increase (%)3 44 (bn USD) Import Value 15.7 22.3 21.0 22.8 29.4 23.2 -4.1 -9.4 -7.5 -8.1 -14.1 -5.1 (bn USD) Balance Trade of (bn USD) Source :www.tuik.gov.tr By the end of 1993, government’s attempts to keep the foreign exchange rate under control and to prevent an increase in interest rates, and the annulment of the Treasury tenders for this purpose rendered the crisis inevitable (Gunal, 2001, p.63). However, in 1994, it would be more appropriate to analyze the monetary policies applied in two different periods; that is, before and after April 5. In the early 1994, the domestic borrowing mechanism for the public sector collapsed and the expectation of devaluation, due to foreign deficit, increased. CBRT has made efforts to keep the deficit under control through open market operations during the first quarter (Kepenek, Yenturk, 2001, p.235). The general economic outlook before April 5, 1994 shows that the real economic sector was not built on stable and strong bases, the competitive power of the manufacturer enterprises did not meet global standards, an extraordinary increase occurred in trade balance deficits and therefore a stable growth could not be achieved (Kepenek, Yenturk, 2001, p.235). On top of all these developments, two international rating agencies, Moody’s and Standard and Poor’s, lowered Turkey’s credit rating and three small banks were closed down, which caused the Turkish economy to go into a crisis and contributed to this economic outlook by April 5. Central Bank intervened the interbank money market, which it had not intervened until January 20, 1994, and had to increase overnight interest rates in order to prevent excessive depreciation in the value of Turkish Lira. Besides, interest rates for Government Debt Securities were raised up to 50% and the withholding tax previously imposed on such securities was lifted (Guloglu, Altunoglu, 2002, p. 17). 45 Two main strategies were identified under the stability decisions taken on April 5, 1994. The first one was to re-stabilize the disrupted macroeconomic balances in the short run, and several objectives including decreasing the inflation, re-stabilizing the Turkish Lira, increasing exports and re-establishing disrupted public balances were defined within this framework. April 5 Decisions turned out to be quite successful in realizing the short-term objectives since the inflation rate dropped to its previous levels and the exports increased due to the devaluation in the following years. However, the second, long-term strategy of April 5 Decisions could not be realized successfully because of the failure to take adequate and decisive steps for an economic transformation (Parasiz, 1995, p.188). April 5 Decisions, which embodied the typical characteristics of January 24 Decisions comprised of a combination of preventive measures to introduce gradual solutions for short-term targets, and envisioned shock therapies for long term targets. In this context, the program had the characteristics of a stability program, which involves controlling the nominal money amount, and does not provide much room for wage increases while imposing monetary and fiscal restrictions (Parasiz, 1995, p.188). When the April 5, 1994 Decisions are analyzed in terms of its success in achieving its targeted objectives, following results are obtained (Uludag, Arican, 2003, p. 64); - The program was unsuccessful in preventing the crisis in financial markets, though it was able to halt the negative balances for a temporary period, - GNP dropped by 6% during the crisis year, - Inflation rate did not drop below the 70% level, in line with its pre-1994 trend, - More than 40% of the consolidated budget was transferred to realize public debt interest payments, - The crisis did not end. The reasons of these results can be listed as follows (Egilmez, Kumcu, 2008, p.380381): - Only fiscal policy measures were implemented, no monetary policy was applied 46 in order to decrease the excessive liquidity in the market, - Distrust in the political power continued even after the economic stability program was put into effect, - Measures with respect to institutional structuring were not implemented during the application of stability measures; on the contrary, the Treasury which should have held the largest responsibility in implementation of such measures was turned into an institution managed without any legislation due to the annulment of its incorporation law by the Constitutional Court’s and the government’s inability to put a new law into effect for a long time, - The Treasury was obliged to continue short term borrowing, which contributed to increase in uncertainty in the economic outlook. • Monetary Policy application between 1995 – 1999 In 1995, Turkish economy still had the traces of 1994 crisis. The recovery that started in the second half of 1994 continued also in 1995. With the 1996 monetary program, content of which was not fully announced, Central Bank targeted to limit the increase in domestic assets and to create Turkish Lira Liabilities equivalent to increase in external assets (Orhan, Erdogan, 2008, p. 372). Maintaining financial stability constituted the fundamentals of monetary policies adopted in 1996. Central Bank aimed to control the reserve money and monitor movements in the foreign exchange rates with the 1996 monetary program (Kesriyeli 1997, p. 28). The monetary policies that were applied by the Central Bank of the Republic of Turkey in 1996 and 1997 were not used to keep inflation under control. Therefore, the main objective of the monetary policy was determined to be maintaining financial stability. Within this framework, CBRT tried to maintain short-term interest rates and foreign exchange rates stable. These objectives were met to a certain extent. Since, however, budget deficits were being financed by the sources of the Central Bank of the Republic of Turkey sources, money supply increased rapidly; and consequently the inflation rate increased (Kesriyeli 1997, p. 28). 47 While there were no significant changes in monetary policy in 1997 compared to the previous year; in 1998, it was stipulated that quarterly monetary policies would be imposed. Following the protocol signed between CBRT and the Undersecretariat of Treasury, CBRT declared monetary policies in accordance with the Treasury’s borrowing program, and announced its results to the public. In line with the 70% inflation forecast envisioned for the first half of the year, the reserve money was estimated to increase by 18-20% within the first three months (Gunal, 2001, p.72). Within the framework of the “Monitoring Agreement” signed with IMF on June 26, 1998; Turkey announced a monetary policy for the second half of the year. With the monetary policy announced for the period in question and revised in October, certain changes were made in the targets and the size of “Net Domestic Assets” in the newly generated analytic balance sheet was determined to be a new target variable (Eroglu, 2004, p. 99). Like the previous year, the monetary policy in 1999 was determined in accordance with the objectives of maintaining financial stability and keeping inflation under control. In June, further discussions with IMF took place; and on December 9, 1999 the monitoring program was turned into an “anti-inflation program” that consisted of various reforms. The objective of this program was to reduce the inflation to a single digit figure through an anti-inflationist policy while imposing potential “reforms” by means of World Bank support, in agriculture, social security and public spending to mend the system and to increase productivity again. This three-year stability program was prepared by IMF and presented to the government together with the Central Bank and the Undersecretariat of Treasury and eventually received the government’s support (Orhan, Erdogan, 2008, p. 378). The main macro-economic data that belongs to this period are shown in the table below. Table 3: Macro-Economic Data for Turkey between 1995 and 1999 Growth (%)1 1995 1996 1997 1998 1999 8,0 7,1 8,3 3,9 -6,1 48 Inflation (%)2 93,6 80,4 85,7 84,6 64,9 Money 86,3 70,7 98,5 75,1 80,0 1 USD (TL)4 61.361 108.045 205.740 314.230 542.703 Export Value 21,6 23,2 26,9 26,9 26,6 35,7 43,6 48,5 45,9 40,7 -14,1 -20,4 -21,6 -19,0 -14,1 Issuance Increase (%)3 (bn USD) Import Value (bn USD) Balance Trade of (bn USD) Source :www.tuik.gov.tr • Monetary Policy application between 2000 - 2010 At the beginning of 2000, in order to decrease inflation, a stability program where foreign exchange rate was used as a nominal anchor; monetary and foreign exchange rate policies were supported by structural arrangements and tight fiscal policies, was started to be implemented. Between 2000-2002, the program that aimed to decrease inflation, which used foreign exchange rate as a nominal anchor, was implemented to fulfill the following main objectives (Ercel, 1999): 1. To decrease the consumer inflation to 25% at the end of 2000, to 12% at the end of 2001 and to 7% at the end of 2002, 2. To increase the growth potential of the economy, 3. To provide a more efficient and fair distribution of economic resources. Main economic policies chosen for the successful implementation of this program aimed at fighting against inflation was summarized as follows (Ercel, 1999): 1. Increasing primary surplus through a strict fiscal policy, realizing structural reforms and accelerating privatizations, 49 2. Revenue policy in accordance with the inflation target, 3. Foreign exchange rate and monetary policy applications focused on decreasing inflation - in order to support the contribution of abovementioned tools in decreasing inflation and real interest rates and to adopt a long-term economic perspective. At the end of October 2000, as demand in both domestic market and foreign markets increased, Turkish economy achieved a growth rate of 6.5-7%. However, as banks encouraged the savings for consumption through consumer loans, the decrease in the inflation rate could not reach to the desired levels. During this period, as the interest rates were increasing, banks started to sell off the treasury bills and bonds they held. Thus, banks with liquidity problems were consequently forced to fund the securities they held, and encountered great losses. On the other hand, as foreign investors started to exit from Turkey rapidly, the interest rates were further increased. The failure of this program did not stem from its internal inconsistency but rather from the confidence crisis that was created by banking sector related to the fast transformation enforcement and inability to solve the subsequent liquidity problems (Egilmez, Kumcu, 2008, p.396). In addition to the banking crises experienced in November 2000, the political crisis experienced in February 2001 further caused total erosion of confidence among financial markets; and resulted in a great increase in demand for the Turkish Lira. When the IMF rejected to take the risk that current foreign currency reserves could not be adequate to endure this increase in demand, on February 21, 2001 the Turkish Lira was set to free float, meaning that the foreign exchange nominal anchor was abandoned. This event can be considered as a milestone in Turkish monetary policy (Akat, 2004, p.2). After the foreign exchange nominal anchor was abandoned in in February 2001, shortterm interest rates became the fundamental monetary policy tools of the Central Bank to combat with inflation and it they were solely used to decrease inflation (Yigit, 2002, p. 12). Following the transition to floating foreign exchange policy, the Central Bank has 50 announced that foreign exchange rates would be determined with respect to supply and demand conditions in the market and no interventions would be made to foreign exchange rates unless sudden and extreme fluctuations occur (CBRT, 2001, p.76). Within the framework of the legal regulations that the new program imposed, the most important development concerning the central bank was the change that was made in the Central Bank law. Some of the changes that were imposed by this law are as follows (CBRT, 2001, p.111-113); - Establishing price stability was accepted as the primary objective, - Within the framework of Transparency and Accountability principles, it was determined that the Head of Central Bank should provide a report to Cabinet in April and October each year about monetary policies that were applied and would be applied, - Establishment of the Monetary Policy Committee, - Granting loans to public sector was forbidden. In 2001, within the framework of the monetary policy that was in accordance with the floating exchange rate regime, all the targets were met, except that the money floor as of June 30 slightly exceeded the ceiling values. However, in addition to the crisis in November 2000 and February 2001, as a result of world output’s realizing the lowest growth rate of the past ten years with 2.4% in 2001, Turkey had its share from this situation and contracted by 9.4% (Keyder, 2002, p. 455). Table 4: Macro-Economic Targets of Transition to Strong Economy Program and Realizations 2001 2002 2003 2004 Realization Target Realization Target Realization Target Realization CPI 68,0 35,0 29,7 20,0 18,4 12,0 9,3 GNP -9,4 3,0 7,9 5,0 5,9 5,0 9,9 Primary 5,7 6,5 3,9 6,5 6,2 6,5 6,9 92,0 81,0 78,6 73,0 70,5 69,0 65,0 Surplus/GNP Net Debt 51 Stock/GNP Source : www.tcmb.gov.tr All things considered, the “Transition to Strong Economy Program” that was applied in 2001 did not yield the desired results. Therefore, the 18th stand-by agreement was signed with IMF and starting from 2002, a 3-year program was planned once more. After the Foreign Exchange Rate Targeting strategy that collapsed in 2001, the Central Bank announced its intentions about transitioning to Inflation Targeting strategy and within the scope of Inflation Targeting preparations, it started to implement Implicit Inflation Targeting (Egilmez, Kumcu, 2008, p.397). The primary target of the monetary policy was determined to decrease the inflation rate down to 35% levels by the end of 2002. The Central Bank targeted to reach this objective initially by determining targets for the monetary base, and secondly by transitioning to official inflation targeting regime after pre-conditions were established. To this end, a monetary program was formed to highlight the performance criteria regarding monetary base. During 2002, consistent with 3% real growth rate forecast and 35% inflation target, monetary base was targeted to grow by 40%8. In 2002, the economy grew by 7.8 % and inflation decreased to 30% levels. Trade balance deficit increased by 17.5% year on year basis and reached 4.2 billion dollars. During this period, current account balance deficit was 246 million dollars. For 2003, the annual inflation rate was announced to be 20% and growth projection was announced as 5%. In 2002, it was announced that, until the transition to inflation targeting strategy was completed, the implicit inflation targeting would continue like the previous year. Monetary base ranked among the target indicators again and it was released to public that short-term interest rates would focus on next period’s inflation (CBRT, 2003). However, despite these positive progresses, high interest rate levels and constantly growing trade balance deficit problems in the economy could not be eliminated in 2003, either. The main reasons behind this situation were that since 1990s, 8 http://www.tcmb.gov.tr/yeni/paraprog/2002/standby2002-‐2004.pdf 52 with the economic crises it went through, Turkey lost its long term development perspective, it could not completely string along with the globalizing world order and it was stuck in a vicious cycle of high interest rate based debts. Making real interest payments of approximately 35% in 2001, 22% in 2002 and 28% in 2003 to domestic debts was also noted as an indicator for this situation. Hovering of real interest rates at high levels was the fundamental reason of Turkish economy’s getting drawn into a debt swamp. In 2003, the total debt stock was realized as approximately 85% of Turkey’s GNP (Cortuk, 2006, p.76). In 2004, tight monetary and fiscal policies diligently continued along with the structural reforms imposed. Therefore, dominance of the financial sector in the economy started to gradually decrease; and as of 2004, real interest rates dropped to 10% and total debt stock’s rate to GNP dropped to 75-80% levels. Additionally, Treasury’s maturity of borrowing was extended. For the first time in its history, the Treasury borrowed from the domestic market with a 5-year maturity term. These positive developments caused tangible improvements in the growth data, as well. Particularly the realization of a 9.9% growth rate in 2004 recorded in the history of both the world and the Turkish Republic as the highest growth rates. In addition to growth rate, the inflation rate dropped to single digits in 2004, recorded as 9.4%, showed that significant steps were taken towards establishing price stability. As a result, Turkish economy demonstrated great success in terms of price stability thanks to the implicit inflation-targeting program applied between 2002-2005 following the crisis in February 2001 (Cortuk, 2006, p.77). As can be seen in the table below, although no change or progress was realized in terms of employment and savings, the economic program that was agreed with IMF in 2002 and ended in 2005 achieved its target to a great extent, contrary to the ones that were previously applied. Between 2002 and 2005, there had been some important progress and while inflation dropped, the credibility of the CBRT increased. During this period, the average growth rate reached to 7%. Financial dominance weakened and concerns about sustainability of public debt stock diminished. With the weakening of retrospective indexing in 53 pricing behavior, transition from foreign exchange rate to prices declined. Due to decreased country risk premium, nominal and real interest rates also decreased. Attainment of fiscal discipline had significantly contributed to the success of monetary policy during this period (Kadioglu, 2006, p.19). Figure 5: 2002-2005 Inflation Targets and Realizations Source : www.tcmb.gov.tr In line with the transparency and accountability principles, the Central Bank started to publish quarterly “Monetary Policy Report”, the Monetary Policy Committee convened regularly during 2005 on the 8th day of every month and took decisions regarding interest rates in light of the developments in the economic outlook and these decisions were announced on the following work day. All these positive developments prepared the suitable environment for the transition to explicit inflation targeting. As it was declared at the beginning of 2005, explicit inflation targeting regime commenced to apply starting from January 2006 (Kadioglu, 2006, p.20). CBRT preferred the inflation target to be defined by Consumer Price Index, since such method was considered to be the easiest to follow by everyone and a good indicator of daily life cost estimations. In this respect, the target variable was determined to be the year-end inflation rate, which was calculated by annual percentage change of 2003 54 based Consumer Price Index. During the first phase of the inflation-targeting regime, targets were declared for three-year periods. In line with Turkey’s three years budget plan, year-end inflation targets for 2006, 2007 and 2008 were determined to be 5%, 4% and 4%, respectively (CBRT, 2005). However, starting from the period during which the Inflation Targeting regime was adopted, Turkish economy was exposed to series of external shocks. Between May-June 2006, decrease in the demand for financial assets of developing countries as a result of global liquidity conditions’ changing in favor of developed countries and increased capital outflow from emerging countries also affected the Turkish economy significantly and caused the CBRT to lose control over inflation expectations (Kumcu, 2008, p.140). Table 5: Inflation and Growth Figures Realized Between 2005 and 2009 Inflation Growth 2005 7.7 7.6 2006 9.65 6 2007 8.39 4.7 2008 10.06 0.7 2009 6.53 -‐4.7 Source: www.tuik.gov.tr In order to prevent any permanent effects that such developments might cause on the pricing behavior, Central Bank applied a monetary tightening policy. As a result, for the first time since the implicit inflation-targeting regime started to being implemented, there was a significant increase in interest rates and a possible intensifying of the adverse effects of the crisis was substantially prevented. Besides, target inflation rate could not be achieved and it was realized to be 9.65% in 2006 (CBRT, 2007). In 2007, interest rates started to decrease gradually. During this period, the overnight borrowing rate was lowered by 175 basis points in total and decreased from 17.50% level to 17.75% level until the end of 2007. The real sector started to be affected by the crisis and a standstill period started. GDP growth rate dropped to 4.7% in 2007. Inflation was realized to be 8.39 percent9. 9 http://www.tcmb.gov.tr/yeni/duyuru/2007/Baskan_2008Parapol.pdf 55 In 2008, the year of global financial crisis, the channels through which Turkey was affected by the crisis came to fore as decreasing fund raising opportunities from global fund markets and a decline in exports. As a result, due to significantly exceeding the inflation targets for two years in a row in 2008 and the expectation that it would be exceeded in the third year as well, caused weakening of the function of inflation targeting as a reference for expectations. In order to bring the inflation expectations under control again and re-establish the confidence for the regime in effect, the Central Bank envisioned that the persistence of this situation would lead to higher costs in combating with inflation, and therefore suggested through an open letter written to government in 2008 that new targets should be determined for medium term. It was advised in the letter that nominal anchor characteristics of inflation target were lost and therefore inflation expectations should be updated as 7.5% for 2009 year-end and 6.5% for 2010 year-end; and it should be determined to be 5.5% for 201110. 2008 year-end inflation was realized as 10.06 percent. In conclusion, from 2009 overnight interest rates, CBRT decided to lower the Central Bank borrowing interest rate to 6.50 percent; lending interest rate to 9 percent, and to lower the borrowing interest rate which was provided to market maker banks through repo transactions for overnight or one week terms, to 8 percent11. In 2009, inflation was realized as 6.53 percent. In 2010, the global economic outlook continued to dominate the domestic economic outlook. In addition to the slow recovery anticipations in advanced economies, the probability of a second round of quantitative easing by the central banks of advanced economies, which were already pursuing unusually loose monetary policies, has increased. These expectations have consequently increased capital inflows to emerging markets, whilst causing a significant increase in commodity prices. The abundant global liquidity, due mostly to the loose monetary policies of advanced economies, and the escalating search for yields have put the emerging markets, including Turkey, in the spotlight. Turkey’s country specific developments, such as better than expected 10 http://www.tcmb.gov.tr/yeni/duyuru/2007/Baskan_2008Parapol.pdf http://www.tcmb.gov.tr/yeni/duyuru/2009/DUY2009-‐63.pdf 11 56 economic activity recovery, credit agencies signal of a possible upgrade, lessened political uncertainty, and the updated Medium-Term Program (MTP) that showed the commitment to the fiscal discipline, have only increased this phenomenon. As a result of these developments, market rates have decreased, stock market has risen and the Turkish lira has appreciated (CBRT, 2010, p.1). Figure 6: Capital Flows to Emerging Markets Source: EDFR Global During this year, domestic demand remained relatively strong. However, due to weak external demand, aggregate demand conditions continued to incite disinflation, which resulted the core inflation to decline to historically low levels. Thus, the Monetary Policy Committee (the Committee) decided to keep policy rates constant for a while, and low for a long period (CBRT, 2010, p.3). As the capital inflows towards emerging countries increased since the end of 2009, CBRT expected the continuation of a strong domestic demand and weak external demand. With regards to these anticipations, it has warned against rapid credit growth accompanied with current account deficit risks and raised concerns about financial stability. In this respect, CBRT has reversed, to a large extent, the temporary liquidity 57 measures that it has implemented during the crisis period. Hence, it has gradually withdrawn excess liquidity, and implemented an increase in required reserve ratios. Furthermore, it has stopped the remuneration of required reserves in order to ease the use of alternative tools of macroprudential policy, and has changed the operational framework of liquidity management. Ultimately, in addition to these measures, CBRT has introduced a new scheme for foreign exchange purchase auctions (CBRT, 2010, p.3). During this period, despite the increase in the consumer inflation, core inflation indicators reached historical low levels, which helped anchoring medium term expectations. 12- and 24-month ahead inflation expectations were slightly above the year-end targets of 5.5% for 2011 and 5% for 2012. Due to the sharp decline in unprocessed food prices and less than expected increase in food prices (year-end realized 7.02%, October 2010 estimate 10.5%), the inflation rate dropped by 2.83 percentage points, to the rate of 6.4%, almost reaching the year-end target (CBRT, 2011, p.1) In sum, given the weak global economic outlook and capital inflows towards emerging countries, risk premiums for emerging economies have decreased, which posed a risk to the macroeconomic and financial stability. This has initiated the CBRT to use its alternative policy tools, such as reserve requirements and liquidity management, and to introduce the unorthodox monetary policy mix at the end of 2010. 2.2. THE UNORTHODOX MONETARY POLICY IN APPLICATION: 2010 PRESENT Fed’s second round of QE (QE2), which in total injected $2.3 trillion of liquidity to the markets, and the European sovereign debt crisis, which caused an erosion in investor confidence, consequently increased capital inflows to emerging markets. These developments were the main driver behind the significant changes in CBRT’s monetary policy strategy. These exceptionally loose monetary policy measures applied by 58 advanced economies have not only increased the global liquidity, but also stirred the search for yield, resulting in even more capital flows to emerging countries (CBRT, 2011-I, p. 1-3). This increasing flow of hot money into Turkey via bond and equities market can be observed in the below graph. Accumulated Equity and Bond Flows by Foreigners (bn USD) 80 60 40 20 0 Equity Flows by Foreigners Bond Flows by Foreigners Figure 7: Accumulated Foreign Flows to Turkish Equity & Debt Markets Source: CBRT Furthermore, the weak recovery in these advanced economies, which are Turkey’s main export destination, resulted in a significant decline in external demand growth. Robust credit growth amid ever-increasing short-term capital inflows, low levels of interest rates across the globe have reinforced the divergence between domestic and external demand and, resulted in a rapid widening of the current account deficit in 2010, which in turn required macroprudential measures12 (CBRT, 2011-I, p. 1-3). 12 During 2010 – 2011, current account deficit level rose to a very high level of 10% of GDP due to the fast growth in domestic demand. 59 Figure 8: Current Account Balance Source: CBRT, Turkstat Turkey's Annual CAD as a % of GDP 3.0% -‐2.0% -‐7.0% -‐12.0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Annual CAD as a % of GDP Figure 9: Turkey’s CAD as a % of GDP Source: CBRT & TSI This so-called “new normal” economic framework has required CBRT to implement a new strategy that compromises monitoring of the financial stability, whilst keeping the 60 main objective of maintaining price stability. Core inflation indicators were in accordance with the medium-term inflation target, thus leaving enough space for the monetary policy to focus on financial stability. Therefore, the CBRT has implemented a policy mix, by diversifying its set of policy instruments, integrating the active use of alternative instruments, such as liquidity management facilities and reserve requirements in addition to the short-term policy rates, which is the 1-week repo auction rate, its main policy instrument (CBRT, 2011-I, p. 1-3). CBRT’s initial public claim for this unconventional policy mix was that the global financial crisis highlighted the fact that ignorance of financial stability threatens both the price stability objective and, in the long run, the macroeconomic stability (Basci and Kara, 2011). Before the financial crisis, it was believed that the price stability should be the primary objective of central banks, which would then result in financial stability. However, this methodology overlooked potential asset bubbles and possible economic and financial shocks that would remarkably damage the healthy functioning of economies. It is evident that inflation rates were at significant low levels before the onset of the crisis; yet, this price stability didn’t stop financial crisis from happening13. Thus, it can be stated that price stability is a critical element of a healthy economy, but not enough to maintain financial stability by itself (Ersel, 2012, p. 43). Furthermore, another reason for the new macroprudential policy implemented by the CBRT after 2010 was the ever-appreciating Turkish Lira and the risk of increasing imports and the current account deficit. The similar patterns in other emerging economies had already raised the question of designing a more flexible and innovative monetary policy mix which would take these macro economical concerns into account (Bianchi and Mendoza, 2010, p.47). Therefore, given the current economic climate, the Monetary Policy Committee (MPC) has decided that the combination of lower policy rates and higher reserve requirement ratios is the most suitable policy mix in order to conjointly observe financial stability and price stability, and furthermore introduced the “interest rate corridor” notion. In this regard, the MPC decided to: “reduce the 1-week repo auction rate, the policy rate, from 13 A good reference for relevant information can be found in the IMF World Economic Outlook. 61 7 percent to 6.25 percent at December 2010 and January 2011 meetings. In addition to policy rate cuts, the CBRT overnight borrowing rate was reduced by 450 basis points to 1.5 percent. The corridor between the overnight borrowing and lending rates was widened to allow for more fluctuations in short-term interest rates when needed. All these decisions aim to encourage capital inflows from short-term to long-term as well as to prevent the Turkish lira to detach from economic fundamentals (CBRT, 2011-I, p. 4). Another constraint while formulating the new policy mix was to limit rapid credit growth, an important factor that contributes to the widening of the current account deficit. In order to achieve this objective, CBRT decided to use reserve requirement ratio as active policy instruments. During December and January, the weighted average of the reserve requirement ratios has increased significantly. Furthermore, reserve requirement ratios were permitted to differ by maturities, with longer-term maturities having lower ratios. This has aimed to slow credit growth whilst extending the maturity of the banking system’s liabilities, thus reducing maturity mismatches (CBRT, 2011-I, p.4) Figure 10: Policy Rates and TL Required Reserve Ratios Source: CBRT, 2011-I, p.4 While framing the new policy measures for current account deficit, the CBRT has stressed its commitment to the primary objective being price stability. Hence, it has 62 underlined that the impact of the new adopted measures, and the measures that are expected to be implemented- within this new policy framework, would result in a tighter stance. By that means, the expansionary effects of the policy rate reductions would be more than offset by the monetary tightening due to increase in the weighted average of reserve requirement ratios (CBRT, 2011-I, p. 4). A further motivation for the new unorthodox policy mix was the drastic and alarming change in the funding scheme of the current account deficit. We can see in the below graph that most of the funding of the current account deficit was fulfilled by the shortterm flows after the second half of 2010. Central Bank of the Republic of Turkey wanted to change this image by aiming to extend the maturities of the flows coming into Turkey and deter the amount of short-term flows (Kilinc, 2012). Figure 11: Main Sources of Current Account Deficit Finance Source: CBRT14 During this period, the benchmark rate, given the CBRT's rate cut decisions and the accompanying downward revisions to future policy rate expectations, kept floating at 14 Short-‐term capital movements are sum of banking and real sectors' short-‐term net credit and deposits in banks. Long-‐term capital movements are sum of banking and real sectors’ long term net credit and bonds issued by banks and the Treasury (CBRT) 63 historically low levels. The downtrend in inflation expectations has only contributed to this phenomenon of market rates decline. The CBRT's rate cuts resulted in a rapid decline of short-term market rates, while longer-term interest rates have declines only moderately due to the obscurity concerning the future course of policy rates. Nevertheless, long-term interest rates remained historically low and relatively stable despite the volatile global risk appetite, signaling a prospective prolonged low interestrate environment in Turkey (CBRT, 2011-I, p. 5). Figure 12: Interest Rates and CPI Expectations in Turkey Source: CBRT, 2011-I, p.5 The illustration below summarizes the new framework and shows the three main tools that have been used effectively; namely ‘reserve requirements’, ‘weekly repos’ and ‘interest rate corridor’. The fundamental objective is to jointly achieve the two objectives, ‘price stability’ and ‘financial stability’. The noteworthy point here is that CBRT uses three intermediary variables, specifically ‘expectations’, ‘loan growth’ and the ‘foreign exchange (FX) rate’. The reason underlying the selection of loan growth and the exchange rate as intermediary variables was that both variables are easily observable and the official data related to loan growth is published weekly. CBRT declared to affect these intermediary variables by changing the three monetary policy tools. Changes in these intermediary variables would then change the definitive objectives as a response to the changes in the policy tools. This dynamic character of the unorthodox monetary policy, by using more than one policy variable in monetary policy decision-making process, gives the CBRT the flexibility of adjusting the policy 64 depending on the current state and objectives in the economy. Thus, CBRT can adjust the intermediary variables accordingly in the future in order to achieve both price and financial stability at the same time. Figure 13: Transmission Mechanism of the Unorthodox Monetary Policy Source: CBRT CBRT gave the signals of a new policy mix in its exit strategy announcement in May 2010 and changed policy rate from overnight borrowing rate to weekly repo lending rates, which was set to 7% (CBRT, 2010). In October 2010, CBRT decreased the overnight interest rates from 6.25% to 5.75% in order to dismiss short-term flows. In November, the overnight borrowing rate was decreased to 1.75% by 400 bps; and then to 1.5% in January 2011, where the weekly policy rate was 6.25%. Nonetheless, overnight lending rate was 9% and this difference between the overnight borrowing and lending rates created an interest rate corridor of 7.5%. By using this interest rate corridor, CBRT’s aim was to avoid short-term funds by decreasing the overnight borrowing repo rate at which short-term funds were placed. The interest rate corridor meant uncertainty for both external funds and domestic banks. Furthermore, CBRT increased the reserve requirement ratio and diversified the eligible reserves according to the banks’ deposit maturities, since deposits are the largest liabilities in the Turkish banking system. The rationale behind was to improve banks’ balance sheets, and to mitigate the credit supply. Looking at the overall picture, the new unorthodox policy 65 mix took off with the decrease in the overnight interest rates, implementing the weekly repo rate as the policy rate, increasing and diversifying reserve requirement ratio, and the active use of the interest rate corridor. The graph below shows how the overnight rate, CBRT overnight borrowing and lending rates and CBRT policy rate evolved since May 2010, when the first signals of the new unorthodox monetary regime were given. The interest rate corridor – the difference between overnight borrowing and lending rates –form barriers for the market overnight rates. This consequently gives CBRT the flexibility to adjust the corridor in order to control the level of the market overnight interest rates. Yet, this move certainly affects the market yield curve too. A reason for this is that if the market rates at which banks borrow from and lend to each other overnight are moved, then this change further transmits to the other parts of the yield curve, finally reaching the long-end of the curve. When the long-term yields are affected, consequently the real economic activity is affected, since the short-term interest rate is adequate to seize the impact of monetary policy on the economy (Borio, 2011, p.3). Accordingly, by creating a new instrument called ‘interest rate corridor’, CBRT aimed to influence the real economic activity via consumption and investment decisions, which are linked to credit growth and the current account deficit. Market O/N & Policy Rates 13.00% 11.00% 9.00% 7.00% 5.00% 3.00% 1.00% CBRT O/N Lending Rate Market O/N Rate CBRT Policy Rate CBRT O/N Borrowing Rate Market O/N Rate CBRT O/N Borrowing Rate CBRT O/N Lending Rate CBRT Policy Rate Figure 14: Market O/N & Policy Rates, Source: CBRT & ISE 66 Short-term interest rates in the market are determined by the level of demand and supply for overnight funds. CBRT uses the interest rate corridor in order to affect interest rates and the liquidity in the market. Within the context of the new monetary policy mix and in order to ease the liquidity management of the banks and further enable them to foresee their total funding costs, CBRT announces the minimum funding that is planned to be delivered through the 1week repo auctions. Furthermore, in October 2011, in order to limit the adverse effects of the global economic developments and to be able to allocate liquidity more efficiently, in addition to 1-week repo auctions, the CBRT has initiated 1-month repo auctions on every Friday, through the traditional method. This resulted in a “weighted average funding rate” for the market, which CBRT settled as its effective policy rate. This provided CBRT the flexibility to determine the policy rate daily. Hence, by observing the volume and quality of the incoming foreign funds flows, CBRT became adept to change the rates daily without waiting for the monthly Monetary Policy Meetings (CBRT, 2012-1, p.78). Thus, this new unorthodox monetary policy mix, unlike the traditional monetary policy regime, gave Central Bank of the Republic of Turkey the flexibility to adjust the rates quickly and frequently, in cases where needed. This resulted in changes in the level and volatility of the exchange rate and the credit growth channels, which subsequently contributed to jointly provide financial stability and price stability15. 15 The exchange rate that CBRT followed was a equally weighted basket of USD/TL and EUR/TL. 67 Figure 15: Market Liquidity Source: CBRT 2.3. EFFECTS AND OUTCOMES OF THE UNORTHODOX MONETARY POLICY - The Effect of the Interest Rate Corridor on the Exchange Rate Channel And Credit Growth Channel: The increase in the incoming foreign fund flows pushes the local currency to appreciate. This abundance of liquidity further increases credit growth, and coupled with the currency appreciation causes a remarkable rise in imports, as happened in Turkey. This situation was even more drastic in Turkey since it has already had historical problems concerning these macroeconomic variables. Thus, CBRT, aware of the fact that this would eventually threaten financial stability, took the necessary measures through the new unorthodox monetary policy mix in order to eliminate the adverse effects of these short-term flows (Kara, 2012, p.10-19). At the end of 2010, CBRT decreased the lower band of the interest rate corridor from 6.5% to 1.5%. This widening of the interest rate 68 corridor meant a higher level of uncertainty for these foreign fund flows. Therefore, considering a risk/return profile in terms of Sharpe Ratio, the money market somewhat lost its attraction for these funds, due to the use of the interest rate corridor and the increasing risk perception. This managed uncertainty in the interest rates creates a risk for short-term funds that are seeking high yields, and thus works as a counter-move tool against currency appreciation (Kilinc, 2012). After October 2011, CBRT became able to affect banks’ credit granting conditions, by dynamically changing the weighted average cost of funding on a daily basis, as explained in the previous subsection. Within this framework, the cost of funding should be adjusted and kept within interest rate corridor every day, so that the width and the uncertainty vis-à-vis cost of funding can greatly influence the banks with high liquidity needs. Hence, these banks will be more prudent in granting loans and will decrease the amount of credit grated. Since CBRT is a net lender via open market operations, banks are becoming even more careful while granting loans (Kara, 2012, p.9-10). Due to the increasing uncertainty in the rates, banks significantly decreased their credit supply and, at the same time, had to increase the interest rates they charge for credits. In sum, we can see that the interest rate corridor can be effectively used to limit credit growth as well as affect the weighted average cost of funding. 69 Figure 16: Total Loan Growth Rates Source: CBRT - The Effect of Reserve Requirement Ratios on the Exchange Rate Channel And Credit Growth Channel: As explained in the first chapter, the reserve requirement ratio is one of the effective tools of central banks. When the CBRT initially designed the new policy mix in October 2010, it aimed to dismiss short-term foreign fund flows, which threatened financial stability. Yet, keeping in mind that a low level of interest rates would significantly increase credit growth, and thus threaten price stability, CBRT increased the reserve requirement ratio depending on deposits’ maturities, which would tighten the credit supply of banks and allow the Central Bank to jointly achieve both of its targets – price stability and financial stability16. 16 As mentioned before, deposits form the greatest part of liabilities of the Turkish banking system; which explains why CBRT targeted to focus on them. 70 Since the start of the financial crisis, reserve requirements have stirred the attention of central banks for several reasons. First of all, “since reserves are often remunerated below market rates, an increase in reserve requirements acts as an implicit tax on the banking sector and widens the spread between deposit and lending rates (Glocker and Towbin, 2012, p.2). Hence, a rise in the reserve requirement ratios decreases the profitability of banks due to higher interest spreads. Therefore, at the end of 2010, CBRT increased the weighted average of reserve requirement ratio to 13.3%, whilst introducing the ‘weekly policy rate’ and widening the interest rate corridor. CBRT governors expected that this increase in the reserve requirement ratio would increase the cost for banks by 100 basis points. Second, a rise in the reserve requirement ratio reduces the money supply, thus resulting in an economic slowdown. Lastly, an increase in the reserve requirement ratio paves the way for depreciation in the exchange rate and a tighter credit supply, as happened in Turkey after the end of 2010. As of October 14, 2011, CBRT also moderately allowed the Turkish banks to fulfil their reserve requirements in terms of gold and other foreign exchanges, corresponding to their Turkish Lira liabilities. Many banks benefited from this opportunity and CBRT, in turn, was able to accumulate further reserves both in terms of gold and other foreign currencies. This was especially important since Turkey has a high current account deficit problem for many years. This provided certain flexibility in terms of softening the adverse effects of the volatility in foreign fund flows on financial markets. For example, it provided the banks with the flexibility of holding most of their liabilities in terms of foreign exchange during the times when the incoming foreign fund flows increased rapidly, thus avoiding the overappreciation of the Turkish Lira. 71 120 CBRT Reserves, bn USD Total Reserves 100 80 FX Reserves 60 40 20 0 02/01/2009 Gold Reserves 02/01/2010 Gold Reserves 02/01/2011 02/01/2012 FX Reserves Total Reserves Figure 17: CBRT Reserves Source: CBRT The use of reserve requirements is also useful for three main reasons; - Raising the reserve requirement ratio is less likely to attract capital inflows compared to an increase in policy rates, - The use of reserve requirements strengthens the effectiveness of interest rate policy, - Reserve requirements can be used to meet financial stability objectives (Montoro and Moreno, 2011, p.57). Moreover, the use of reserve requirements is exceptionally more useful during periods of financial stress as high risk-aversion prevents the transmission mechanism of policy rates (Quizpe, Rossini, 2010, p. 308). In Turkey, CBRT feared of a rapid growth caused by the foreign fund flows due to the expansionary monetary policies in advanced economies. For this reason, reserve requirements have been a very effective tool, complementing the policy rate, since it solved the dilemma between reducing policy rates to dismiss short-term flows and to increase policy rates to avoid a credit boom. Yet, it should be kept in mind that, although reserve requirements can be used to curb 72 credit growth, they also reduce the effectiveness of financial intermediation whilst increasing the cost of credit. Reserve requirement ratio affects the credit growth through two channels: i) Direct Costs: An increase in reserve requirements means a direct cost for banks that have certain liabilities in their balance sheets. When the CBRT increased the reserve requirement ratio to 13.3% in October 2010, this meant a cost of 100 basis points for banks, which they reflected in the credit and deposit rates. However, this increase did not have a significant effect in the credit supply, thus proves that it remained inefficient to curb credit growth.17 Even after the increase in the reserve requirement ratio, Turkish banks were able to fund themselves cheaply through repo auctions, where the low weekly policy rate was the benchmark. Thus, banks were able to substitute the lost liquidity due to the increase in the reserve requirement ratio with this cheap funding. CBRT continued providing this relatively cheap funding for banks in order to be still in line with its inflation-targeting mandate. Consequently, this limited the anticipated decline in credit supply through the direct cost channel (Kara, 2012, p. 12). ii) Liquidity: The effect of the increase in reserve requirements on credit growth is in fact more effective coupled with the use of the interest rate corridor. Else, the lost liquidity caused by the increase in reserve requirements would be replaced by CBRT’s funding through repo auctions. The joint use of the interest rate corridor and the other liquidity management tools create uncertainty for the banks with higher liquidity requirements. This, consequently, results in these banks decreasing their credit supply, and being more cautious. The uncertainty in short-term rates is especially higher during increasing capital flows, as the CBRT decreases its overnight borrowing rate to overcome the adverse effects of these flows (Kara, 2012, p. 13). 17 Koray Alper and Tolga Tiryaki shows in their working paper that, since Central Bank continued funding banks at low rates, the direct cost of limited reserve requirement ratio increases to banks remained minimal. Source: “Role of Reserve Requirements as a Monetary Policy Tool”, CBRT, April 2011. 73 - The Effect of the Exchange Rate Channel and Credit Growth Channel on CBRT’s dual objectives: Price Stability and Financial Stability: The foreign exchange effect on economy cannot be neglected in Turkey since Turkey is a net importer country and the economic growth is well linked with import substitution. When the currency depreciates, it results in a value increase of imports in Turkish Lira. If Turkish Lira potentially depreciates by 10% against an equally weighted basket of US Dollar and Euro, inflation is therefore expected to increase by 1.5% over one year. More importantly, this 1.5% inflation increase can be observed in the first 6 months (Kara and Ogunc, 2011, p.6). This explains why moving the level of Turkish Lira through the new monetary policy affect price stability. Credit channel has a direct impact on the economic activity and the current account balance. Its importance can be clearly observed given that the total amount of credit to GDP ratio has reached 50% by the end of 2011. Furthermore, domestic consumption counts almost around 75%, as can be seen in the below graph, meaning that growth is mainly achieved through domestic consumption. The impact of the credit channel is expected to have even more impact on aggregate demand, which is why it is taken into account while designing the monetary policy since it directly affects the current account balance and the medium term inflation pattern (Kara, 2012, p. 14). Credit and exchange rate channels have an effect on inflation mainly through aggregate demand and retail costs (Kara, 2012, p. 14). CBRT is using the new monetary policy tools, such as reserve requirements, interest rate corridor and the other liquidity management tools, to achieve its price stability objective and to maintain inflation close to its targets. 74 80% 78% 76% 74% 72% 70% 68% 66% Contribueon of Consumpeon in Growth Figure 18: Contribution of Consumption in Growth Source: CBRT Defining financial stability is harder than price stability because there are no concrete variables to measure it or one specific definition. Although it is a subjective concept, Michael Foot, the Managing Director of UK Financial Services Authority, once defined it in 2003 as; “We have financial stability where there is: a) monetary stability, b) employment levels close to the economy’s natural rate, c) confidence in the operation of the generality of key financial institutions and markets in the economy, and d) where there are no relative price movements of either real or financial assets within the economy that will undermine (a) or (b).”18 CBRT has a macro perspective regarding financial stability and reviews it mainly within the current account balance and credit growth framework. As explained above, exchange rate influences financial stability through augmenting the current account deficit. Appreciation of the Turkish Lira increases imports, thus increasing the trade deficit levels, which subsequently worsens the already problematic current account deficit. It would further increase the demand for imported products, and therefore exposing the economy to external shocks. Credit channel has very similar 18 http://www.fsa.gov.uk/library/communication/speeches/2003/sp122.shtml 75 effects on financial stability through the current account balance since a rapid increase of credit supply subsequently increases domestic demand, where it means an increasing demand for imported products in Turkey (Kara, 2012, p.14). Overall, as a result of the rationales explained above, CBRT takes into account the changes in the foreign exchange and the level of credit growth while dynamically finetuning its monetary policy actions. Finally, in order to summarize the application of CBRT’s unconventional monetary policy mix and get a holistic view of the policy’s timeline, the policy regime can be examined for three periods of time consistent with the range of tools applied by the CBRT. - Application during November 2010 - August 2011 During this period, the main target of CBRT was to smoothen the adverse effects of the short term foreign capital flows to Turkey, due to the on-going quantitative easing programs (QE2, etc.) in advanced economies, the appreciation of the Turkish Lira and the increasing current account deficit, and thus to provide financial stability. Since the lower than targeted level of inflation left room for the use of other policy tools, CBRT focused its monetary policy to decrease the entry of short tem capital flows in order to limit credit growth, and consequently to curtail aggregate demand. Hence, in order to discourage short-term capital flows, CBRT extended the interest rate corridor downwards, and increased uncertainty in interest rates. At the same time, to balance out this and to limit possible credit growth due to the low level of interest rates, the Central Bank further increased the reserve requirement ratio significantly. This rise in reserve requirements correspondingly resulted in banks increasing their funding from Central bank through repo auctions, and thus strengthened the command of monetary policy on credit supply via liquidity channel (Kara, 2012, p.16). 76 - Application during August - October 2011 Economic outlook during this period was dominated by the Eurozone debt crisis and increasing uncertainty in markets. As the Eurozone debt crisis continued intensifying and the uncertainty increased, the global risk appetite deteriorated, which in turn resulted in a significant decline in the volume of foreign capital flows to emerging countries. Hence, CBRT tightened the interest rate corridor to limit the capital outflows in order to ease uncertainty contrary to what was aimed during the first period of application. In other terms, CBRT actively used interest rate uncertainty as a monetary policy tool. At the same time, in order to limit any downside risks that might cause exogenous demand shocks, CBRT applied a limited reduction in the weekly repo rates. Additionally, the Central Bank provided a considerable amount of FX liquidity to markets to prevent a sudden halt of funding. On the other hand, reserve requirements were still kept at high levels since the credit growth was still relatively high and the short-term interest rates were at low levels (Kara, 2012, p.16 - 17). By looking at these two periods, it can be observed that different policy tools were used during each period to achieve the joint objectives of price stability and financial stability. - Application during October 2011 - Present After October 2011, the inflation pattern started to deteriorate and exceed 10% due to two important factors. Due to the rapid capital outflows from emerging countries, as expressed above, this resulted in a remarkable depreciation of the Turkish Lira. This inflationary pressure was further intensified with the increasing administered good prices. CBRT forcefully responded to these developments by monetary tightening and increased the market-lending rate (CBRT, 2011-IV, p.8). During this period, CBRT decreased the funding it provided to markets via weekly quantity auctions and widened the interest rate corridor upwards by pushing the upper band to 12.5% from 9%. Hence, the short-term market rates rose considerably. Moreover, to prevent a sudden halt in the credit supply due to monetary tightening, reserve requirement ratio was decreased. In February 2012, following the measures taken by the Eurozone countries to solve the on- 77 going debt crisis, the risk of a sudden halt in capital inflows decreased and, accordingly, CBRT tightened the interest rate corridor, by decreasing the upper band rate to 11.5% from 12.5% (Kara, 2012, p. 17). The unconventional monetary policy mix of the Central Bank of Turkey’s main focus has been providing financial stability whilst observing financial stability. This implicitly dual mandate was realized through various monetary policy tools in addition to the traditional policy rate. Within this framework, foreign exchange and credit channel have been the actively used intermediary variables, and they have had a direct impact on the efficiency of the monetary policy application. The intermediate variables, foreign exchange and credit growth, have moved as it was planned, in favour of the monetary policy since October 2010. While the currencies of emerging countries, alongside Turkish Lira, have increased in value against USD until November 2010 in correlation, After this period, with the help of the new monetary policy mix, it has followed a different path and depreciated relatively around 20% until August 2011 when the Eurozone crisis has become more severe. However, as the risk appetite deteriorated after August 2011, the emerging market currencies have rapidly depreciated while the Turkish Lira remained relatively stable. The previous depreciation of the Turkish Lira that was realized before August 2011 prevented further fluctuations in Turkish Lira and excessive capital outflows (Kara, 2012, p.18). Performance of the EM currencies and Turkish Lira against US Dollar since August 2011 to present can be observed in the below graph 78 'USDTRY' vs. 'USD-‐EM Currencies' Performance, between August 2011 -‐ Present 1.2 1.18 1.16 1.14 1.12 1.1 1.08 1.06 1.04 1.02 1 USDTRY Performance Aggregate USD/EM Currencies Performance Figure 19: Performance of TL & Emerging Markets Currencies vs. USD since August 2011 Source: Bloomberg Similarly, the policy has been successful in limiting the credit growth. The total credit growth was 50% at the end of 2010, and it gradually decreased to around 15 - 20% with the help of the unconventional monetary policy mix, becoming more coherent with the moderate GDP growth. It can be seen in the below graph that credit growth slowly responded to the new monetary policy mix and started to slow down gradually following the new measures. As the Banking Regulation and Supervision Agency became involved after mid-2011 by further implementing macroprudential measures, the credit growth significantly slowed, and as the CBRT widened the interest rate corridor upwards and tightened monetary stance, credit growth started to decrease (Kara, 2012, p.19). 79 Credit Growth in Turkey 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% TL Credits -‐ YoY % Change FX Credits -‐ YoY % Change Total Credits -‐ YoY % Change Figure 20: Credit Growth in Turkey Source: BRSA In sum, it can be seen that the credit growth was kept in line with the financial stability objective. The unconventional monetary policy regime had been arranged successful in counterbalancing the capital flows direction and was successful in preventing an such that it countermoves the direction of capital flows in order to balance a hostile capital inflow/outflow. Thus, we can say that Central Bank of the Republic of Turkey has been successful in terms of efficient use of intermediary variables in reaching monetary policy objectives. 3. EVALUATION OF THE CBRT’S UNORTHODOX MONETARY POLICY Until this final chapter, we have primarily seen how central banks function. Afterwards, we have presented the monetary policy application of the Central Bank of the Republic of Turkey since 1980 to present, including the new unorthodox monetary policy, in order to get a holistic framework of the Turkish economy and better understand and assess the monetary policy in question. In the last subsection of Chapter 2, we have seen that the CBRT so far has been successful in using the intermediary variables. In the first subsection of this chapter, we will assess the performance of the unorthodox monetary policy mix in terms of 80 monetary stability and financial stability. We will then present the interviews conducted with the Treasury departments of three big banks in Turkey and the second biggest asset management firm to have an objective view of the monetary policy and to understand how market participants view it, since CBRT has not initially been successful in communicating it to investors. We will also grasp their expectations on the main economic indicators. Lastly, combining the evaluation of the new monetary policy application in the initial subsection and the interviews, a critical analysis of the unorthodox monetary policy will be presented. 3.1. Global Evaluation of the Policy Performance In the previous chapter, we have analysed how CBRT used the credit channel and the foreign exchange channel in order to apply the unorthodox monetary policy mix and we have seen that it has nearly been successful. However, in order to completely assess the performance of the policy mix, we need to look at how successful it has been in achieving its implicit dual objectives: price stability and financial stability.19 While evaluating the performance of the new policy mix, the main parameter used for financial stability is the current account balance; while the parameter used for price stability is inflation and inflation expectations. - Financial Stability: One of the motivations behind the new unconventional mix of CBRT was to limit the cyclicality of the current account deficit. By achieving that, CBRT aimed to increase the endurance of the economy against a possible halt in foreign capital flows. Thus, they aimed to reduce the current account deficit and to bring it funding scheme to a healthier pattern, and we can say that they have been successful in that sense. We can see in the below graph that the current account deficit has remained resilient around 10% of GDP for some time and then started to decrease around mid-2011; yet, it is still expected to decline further. By the first quarter of 2012, current account deficit excluding energy was almost eliminated. It is also observed in the graph that the current account deficit 19 As mentioned in the previous chapter, CBRT’s main monetary policy objective is price stability. However, after late 2010, it has stated that its objective is to maintain price stability, while observing financial stability. 81 level is lagging for two quarters after the implementation of the unconventional policy mix (Kara, 2012, p.20). The remarkable fact here is that it is statistically more problematic for the current account deficit to return to a high-state level from a lowstate level. Therefore, if the central bank achieves to maintain the current account deficit at low levels, there may arise an opportunity for policy makers to keep it at low levels for a long period of time, which will emphasize further the significance of monetary policy in terms of financial stability (Akcay, Ocakverdi, 2012, p. 88-91). 20000 10000 0 -‐10000 -‐20000 -‐30000 -‐40000 -‐50000 -‐60000 -‐70000 -‐80000 Annual CAD Level of Turkey (mn USD) Annual CAD Annual CAD exc. Energy Figure 21: Annual CAD Level of Turkey (mn USD) Source: CBRT The funding scheme of the current account deficit has also improved and reached a healthier pattern, alongside the current account deficit. By the end of 2010, the main problem concerning the funding of the current account deficit was that the main portion of this funding was achieved by short-term capital flows; and that there was a remarkable need to change this structure. The new monetary policy mix achieved to increase the proportion of long-term capital and foreign direct investments. However, as can be seen in the below graph, short-term funds still remain the main source of funding the current account deficit (Kara, 2012, p.20). We need to mention here that innovative monetary policy tools cannot solely improve the CAD funding scheme. Turkey needs to implement important structural reforms such as improving its human capital, investing in R&D and technology. Only through this reforms dependence on imported goods can 82 be reduced, and the main export zone can shift from Europe to other emerging countries, which would decrease Turkey’s exposure and vulnerability to advanced economies. Funding of the CAD (mn USD) 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 -‐ -‐10,000 FDI & Long Term Investments Short-‐Term Porholio Flows CAD Figure 22: Funding of the CAD (mn USD) Source: CBRT - Price Stability: During the last quarter of 2011, annual inflation has reached 10,5%, which is considerably above CBRT’s target inflation level of 5%. However, it was not merely related to the inefficiency of the monetary policy, it was more a result of several external factors combined and these external factors and one-off items contributed to 5.1% of the annual inflation, as presented by many central bank governors. 83 12.0% Annual InflaXon (%) 10.0% 8.0% 6.0% 4.0% 2.0% Annual Inflaeon (%) CBRT Target (%) Figure 23: Annual Inflation Source: TSI The price of imported goods and unprocessed food prices, and more than expected tax on tobacco were the main contributors to the annual inflation, 2%, 1.1%, 2% respectively. Since they are regarded as one-off items, CBRT did not change its expectation of a decline in annual inflation in 2012 and remained determined to this medium-term inflation target level of 5%. We can observe in the below graph that inflation expectations follow a stable path and there is no deterioration in the 12- month and 24-month expected medium-term inflation level despite this high level of inflation, 10%. This is very important in the sense that, after the sudden hike in inflation in 2006 and 2008, there was a sharp deterioration in the medium-term expected inflation levels, as can be observed in the graph. However, after the implementation of the new unconventional monetary policy mix, medium-term inflation expectations did not deteriorate. This proves that the policy regime has been successful in keeping the inflation expectations under control, which is another positive characteristic of the unconventional monetary policy mix since it gives significant importance to inflation expectations whilst deciding on target inflation levels (Kara, 2012, p.21-22). 84 InflaXon ExpectaXons 9.5% 9.0% 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 15/01/2007 15/01/2008 15/01/2009 15/01/2010 12 Months Inflaeon Expectaeon 15/01/2011 15/01/2012 24Months Inflaeon Expectaeon Figure 24: Inflation Expectations Source: CBRT Overall, the unconventional monetary policy mix seems to have a more positive effect on financial stability compared to price stability. CBRT almost fully achieved its goal of financial stability. Even though it can bee seen that the CBRT is not neglecting price stability while observing financial stability, the fact that the medium-term inflation expectations are still higher than initially targeted proves that the CBRT has not been successful in achieving price stability. This is the main weakness of the new unorthodox monetary policy mix (Kara, 2012, p.22). 3.2. Empirical Research: Interviews The unorthodox monetary policy mix of CBRT has received significant attention from financial markets and institutions. Mainly because it was an unorthodox policy with unconventional tools that market participants were not used to, but also CBRT initially failed to communicate the policy in a clear and comprehensible manner, which created confusion mostly for foreign participants. In this chapter, interviews are done with the Treasury departments of major Turkish and foreign banks, which were affected first hand with the new policy mix and the Fixed Income Portfolio Managers and the strategist of the second biggest asset management 85 firm in Turkey. Since inflation expectations are a part of monetary policy decisions, questions reflect the inflation expectations, and also the expected FX and CAD levels. This will help the readers to assess if the targets of CBRT are realizable and line with the market participants. INTERVIEWS 1. What is your annual consumer inflation expectation (%) for; - The end of current year? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI AK ASSET AK ASSET AK ASSET #1 #2 #3 6.4% 7% 7% 6.15% DEUTSCHE YAPI ING AK ASSET AK BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT 6.3% 6.3% Mean: 6.525% - 12 months later? KREDI BANKASI 6.3% 5.9% 6.2% #1 #2 #3 6.5% 7.4% 6.3% Mean: 6.43% ASSET AK 86 ASSET - 24 months later? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI 6.5% 5.7% 5.8% AK ASSET AK ASSET AK #1 #2 #3 6% 6.9% 6.20% ASSET Mean: 6.18% 2. What is your expectation for overnight interest rate established in repo - reverse repo market (%) for the end of current month? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI AK #1 ASSET AK #2 ASSET AK ASSET #3 5.40% 5.5% 5.70% 6.75% 5% 5.6% Mean: 5.66% 3. What is your expectation for the CBRT one week repo rate (policy interest rate) (%) for; - The end of current month? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI AK #1 87 ASSET AK #2 ASSET AK #3 ASSET 5.50% 5.75% 5.75% 5.75% 6.3% 5.75% Mean: 5.8% - 3 months later? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI 5.50% 5.75% AK #1 5.75% 5.75% ASSET AK ASSET AK #2 #3 6.4% 5.75% ASSET Mean: 5.81% - 6 months later? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI 5.50% 5.50% AK #1 5.75% 5.50% ASSET AK ASSET AK #2 #3 6.7% 5.75% ASSET Mean: 5.78% - 12 months later? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI 5.50% 5.25% 6% AK #1 #2 5.50% 6.7% Mean: 5.78% ASSET AK 88 ASSET AK #3 5.75% ASSET - 24 months later? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI 5.50% 6.50% 6% AK ASSET AK #1 #2 5.50% 6.7% ASSET AK ASSET #3 5.50% Mean: 5.95% 4. What is your expectation for the Interbank USD/TL exchange rate for (TL); - The end of current month? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI 1.80 TL 1.81 TL 1.81 TL AK ASSET AK ASSET AK #1 #2 1.80 TL 1.8240 TL ASSET #3 1.80 TL Mean: 1.807 TL - The end of current year? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI 1.82 TL 1.80 TL 1.82 TL AK ASSET AK #1 #2 1.815 TL 1.8220 TL Mean: 1.8095 TL ASSET AK 89 #3 1.78 TL ASSET - 12 months later? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI 1.85 TL 1.75 TL 1.78 TL AK ASSET AK ASSET AK #1 #2 1.825 TL 1.8450 TL ASSET #3 1.81 TL Mean: 1.81 TL 5. What is your expectation for annual current account balance (Million USD) for; - The end of current year? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI 62 mn USD 65 mn 63 mn USD USD AK ASSET AK ASSET AK #1 #2 63 mn USD 60 mn USD ASSET #3 61 mn USD Mean: 62.3 mn USD - The end of next year? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI 70 mn USD 65 mn 69 mn USD USD AK ASSET AK #1 #2 66 mn USD 66 mn USD Mean: 66.5 mn USD ASSET AK 90 ASSET #3 63 mn USD 6. What is your expectation for annual GDP growth (%) for; - The end of current year? DEUTSCHE YAPI ING BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT KREDI BANKASI AK ASSET AK ASSET AK ASSET #1 #2 3.8% 3.9% 4.1% DEUTSCHE YAPI ING AK BANK BANK MANAGEMENT MANAGEMENT MANAGEMENT 3% 4% #3 3.8% Mean: 3.77% - The end of next year? KREDI BANKASI 3.75% 5% 4.8% ASSET AK #1 #2 5% 5% ASSET AK #3 5% Mean: 4.758% 7. What changes do you expect in CBRT’s monetary policy mix in the upcoming three months? Deutsche Bank: We are expecting a 100 - 150 bps decrease in the upper band of the interest rate corridor. Yapı Kredi Bankası: Since all major central banks in the world are further decreasing their interest rates, we are expecting the CBRT to also decrease interest rates unless there is no major change in the global economic outlook. We are expecting a decrease in the upper band of the interest rate corridor by 50100 bps in the first following Monetary Policy Committee Meeting, then a further decrease by 200 bps later on. 91 ASSET ING: We are expecting a 200 bps decrease in the upper band of the interest rate corridor, while keeping the lower band of the interest rate corridor as it is. We are not expecting any change in the policy interest rate in the next three months. Ak Asset Management #1: I expect an easing in the monetary policy due to the low levels of growth and to the fact that local elections are scheduled to take place next year. Due to the weakness in advanced economies, there is a perception towards decreasing inflation. Thus, I expect a gradual tightening in the interest rate corridor. We can see a 50 bps decrease in the upper band of the interest rate corridor in the first MPC meeting, and a further 100 bps later on depending on the quantitative easing programs that Fed and ECB will take place. Ak Asset Management #2: I expect a tightening in the interest rate corridor. Ak Asset Management #3: I expect a decrease in the upper band of the interest rate corridor. 8. Do you find CBRT’S unconventional monetary policy mix successful in terms of achieving its stated objectives? Yapı Kredi Bankası: We find CBRT’s monetary policy mix successful since the beginning of 2012. We believe that CBRT has been successful in keeping the FX levels in the target range with the help of the global economic improvement. CBRT has supported the “soft landing” of the economy by implicitly decreasing interest rates. Even though it is not expected that CBRT will achieve its annual year-end inflation target, it has been successful in increasing its credibility. Furthermore, in the beginning of 2012, most foreign banks were expecting either negative or close to 0 GDP growth levels in Turkey for 2012 year-end. However, they had to revise their estimates upwards in the second quarter. CBRT seems to have been successful so far in achieving “soft landing”. Our main concern about the unorthodox monetary policy mix is that 92 since it is unconventional and complex, it is hardly understood by foreign financial institutions and investors and thus, creates a risk premium for Turkey. CBRT should be more clear and precise while communicating its monetary policy decisions. ING: Yes. Ak Asset Management #1: Despite the fact that Turkish economy is positively affected by the contraction in the global economy, a higher-level inflation is expected due to the increase in budgetary deterioration, cheap energy prices, and further quantitative easing programs in the advanced economies will cause on foreign exchange and commodity prices. Even though the government has announced that no special economic program will be applied because of the elections, there is an ever-increasing investment in infrastructure problem in municipalities. Financing these investments through additional debt or tax might cause an increase in interest rates. However, CBRT can be successful through additional foreign capital flows, which would enter Turley if rating agencies increase Turkey’s grade. Ak Asset Management #2: Partially yes. Ak Asset Management #3: Yes, thanks to its flexibility and difficult predictability. 3.3. Critical Analysis of the CBRT’s Unorthodox Monetary Policy The unorthodox monetary policy mix of CBRT has been designed and used for the first time in Turkey. Transmitting the new monetary policy mix, along with the absence of supporting financial data and theoretical background, caused problems in communicating this unconventional policy mix, as also mentioned in interviews. Furthermore, since there wasn’t any other institution to take measures against intense capital flows, the central bank had to intervene and take precautionary measures in terms of monetary policy. 93 As mentioned above before, CBRT has been successful in providing financial stability and, to a lesser extent, price stability. In order to assess the performance of the unconventional policy mix, current account deficit target level is used for financial stability, and target inflation level is used for price stability. When we observe these parameters while evaluating the performance of the monetary policy, it can be observed that there have been significant improvements. However, it can be said that these target levels are not at their optimal levels; in other words, achieving these targets are far from sufficient in adding value to the real economy. When we look at the inflation expectations graph, we can see that inflation expectations haven’t deteriorated after the implementation of the policy mix –even when the annual inflation was above 10% -, there still remains great ambiguity over whether CBRT will be able to achieve its medium-term inflation target of 5%. When we look at the answers of market participants’ interviews in the previous section, annual inflation estimates for 2012 year-end and next year is observed to be around 6.5%. Furthermore, even though the current account deficit has improved and its funding scheme started to contain long term investments more, there still should be further improvement in order to decrease the vulnerability of the economic outlook. As can be observed from the answers in the interviews above, the year-end current account deficit is estimated to be around 62.3 million USD for 2012, and 66.5 million USD for 2013. This shows us that, although the monetary policy mix has been successful to an extent since its implementation in late 2010 until present, it remains insufficient to keep current account deficit under control. However, as mentioned previously, current account deficit cannot be solely reduced by monetary policy, but there are more structural reforms needed concerning investment in R&D and technology, and education. One of the policy tools that the CBRT actively used in its unconventional monetary policy mix is the reserve requirement ratio. CBRT started using this tool more actively starting from late 2010, and increased the reserve requirement ratio with the aim of slowing down credit growth. However, at the same time, CBRT continued to provide liquidity to banks through open market operations. Since weekly policy rates were at very low levels, banks continued to fund themselves through repos in order to compensate the loss that occurred from increased reserve requirements and accordingly, 94 to lend and supply credit. CBRT had to continue providing this liquidity since it has an explicit inflation target and needs to provide certain amount of liquidity to the market so that the market rate can converge to CBRT’s policy interest rate. Thus, reserve requirements was not very successful on its own but it became a more efficient tool along with the interest rate corridor, since the ladder created uncertainty in levels of interest rate. In the graph below, positive level of open market operations shows the volume of shortterm loans that the CBRT provided banks through repos. It can be observed that the level of reserve requirements and open market operations are highly correlated, which shows that the reserve requirements alone, if not supported with another policy tool, is not effective in curbing credit growth. 80,000,000 70,000,000 60,000,000 50,000,000 40,000,000 30,000,000 20,000,000 10,000,000 -‐ -‐10,000,000 OMO Reserve Requirements Figure 25: Reserve Requirements and Open Market Operations (OMO) (mn TL) Source: CBRT Central Bank of the Republic of Turkey has carried out an experiment with this unorthodox monetary policy mix on the Turkish economy to maintain financial stability. As can be seen in Figure 16, the intervention of the Banking Regulation and Supervision Agency (BRSA) and the additional macroprudential measures it has implemented in June 2011 through its Financial Stability Committee, in order to further 95 limit credit growth and increase the efficiency of monetary policy in achieving it, resulted in a significant decrease in credit growth. Thus, the question that can be asked here is that what would have happened and would the monetary policy be as successful as it is today in maintaining financial stability if the Banking Regulation and Supervision Agency did not contribute to the monetary policy (Ozatay, 2012, p.13). Another important point that can be raised concerning the involvement of the Banking Regulation and Supervision Agency in the monetary policy process is that the BRSA had been late in joining the process. Akcay and Ocakverdi (2012) state in their paper that the reason why CBRT was able to achieve its goal of decreasing credit growth later than expected comes from the “exclusion of the BRSA in the initial package and thus the absence of punitive sanctions on aggressive lending motives.” Another criticism that Ozatay (2012) has raised in his paper is the existence of two different institutions that are in charge of financial stability. He proposes that, instead, some of BRSA’s powers should be transferred to the Central Bank and CBRT should exclusively be responsible in taking macroprudential measures concerning financial stability. Otherwise, it would jeopardize either the independency of central bank or the autonomy of the BRSA. Increase in reserve requirements represents an additional tax liability for banks. Thus, after it was increased, banks looked for alternative funding solutions with lower costs. Accordingly, it stirred corporate bond issuance by banks, which wasn’t common before in Turkey, and Eurobonds. The volume of syndicated loans provided by international financial institutions also increased drastically. This increase also encouraged banks to remove items off-balance sheet items during certain periods. After 2010, CBRT has sacrificed price stability to an extent in order to maintain financial stability, which became increasingly important due to the negative global economic outlook. 12-month and 24-month inflation expectations may have not deteriorated significantly, but the inflation level has increased above 10% during 2011 and the first months of 2012. Although the Central Bank is determined to maintain its medium-term inflation target level at 5%, medium-term inflation estimates are higher 96 than 5%, which, after a certain point, might deteriorate medium-term inflation expectations, and harm the real economy. 97 CONCLUSION Aftermath the financial and economic crises that started with the subprime mortgage crisis, global economic conjuncture has remarkably changed and capital flows were directed to emerging countries. Turkey has been one of the countries that have attracted these capital flows. Central Bank of the Republic of Turkey had to take additional measures to prevent the possible negative impacts of these capital flows, mainly widening of the current account deficit, credit growth and an unhealthy funding scheme of the current account deficit. Thus, CBRT took on the role to provide financial stability and adopted an implicit mandate with dual objectives, which are price stability and financial stability. During late 2010, CBRT started to apply the so-called “unorthodox” policy mix, which incorporated an increase in reserve requirements, use of the interest rate corridor and other liquidity management tools, in addition to the traditional policy rate. CBRT aimed to achieve financial stability in addition to its primary objective of financial stability through affecting the credit growth channel and the foreign exchange channel by using a combination of these policy tools. When analyzed since the start of its implementation, it can be seen that this unconventional monetary policy mix has been successful in preparing the Turkish economy to “soft landing”. Current account deficit, which was at a 40 percent level before this policy mix, has been following a decreasing trend and reached almost 15 percent. Long-term investments also increased its portion in the current account deficit scheme since this application. Although it can be argued that this unconventional policy mix has been less successful in achieving and maintaining price stability, it was successful in preventing the deterioration in medium term inflation expectations. However, the inflation outlook can rapidly change if the quantitative easing in advanced economies continues. This might require the CBRT to take additional measures of monetary tightening. Overall, CBRT has been mostly successful with the “unorthodox” monetary policy mix. Since it is a fairly recent policy mix, it is not possible to capture all aspects and fully assess its performance. CBRT will have to dynamically adjust its tools with the rapidly 98 changing global economic conjuncture and if proves successful, it might represent a good example for other central banks. 99 BIBLIOGRAPHY Akat, A. 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