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Capital Flows, Financial Stability, and Monetary Policy Hakan Kara Central Bank of Turkey Anadolu International Conference in Economics June 19, 2013, Eskişehir Outline 1. 2. 3. 4. 5. Monetary Policy since 2001 Capital Flows and Implications for Monetary Policy New Monetary Policy Framework New Policy Instruments Evidence and Conclusion 2 Monetary Policy Since 2001 2001-2006: Implicit Inflation Targeting (IT) 2006-2008: Full-fledged conventional IT 2009-2010: Adjusting to the post crisis conditions Late 2010-to date: Incorporating Financial Stability Objective into the Inflation Targeting Framework (with special emphasis on capital flows) 3 Capital Flows and Implications for Monetary Policy 4 Portfolio Flows to Emerging Economies Equity and Bond Flows to Emerging Market Economies (4-Week Moving Sum, Billion USD) 30 Bonds Equities 25 20 Collapse of Lehman Brothers 15 10 5 0 -5 -10 -15 04/13 01/13 10/12 07/12 04/12 01/12 10/11 07/11 04/11 01/11 10/10 07/10 04/10 01/10 10/09 07/09 04/09 01/09 10/08 07/08 04/08 01/08 10/07 07/07 04/07 01/07 10/06 07/06 04/06 01/06 -20 Source: Emerging Portfolio Fund Research (EPFR) 5 Gross Capital Flows to Emerging Economies 1,500 1,000 500 0 -500 FDI Liab (in $ bn) Portfolio Liab (in $ bn) Other Investment Liab (in $ bn) 6 Capital flows: challenges Capital flows may have important benefits, but they pose big challenges for macroeconomic policy as well: Sudden reversals (stops) can have very large adverse effects on real and/or financial sector. Procyclical flows amplify macro-financial fluctuations, rather than dampening them. 7 Capital Flows and GDP Growth in Turkey 10 8 6 4 2 0 -2 -4 -6 Net Capital Flows/GDP GDP Growth Rate 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 -8 Source: CBRT 8 Correlations between Capital Flows and GDP Growth 0.50 0.40 0.30 0.20 0.10 0.00 Industrial countries Non-LAC MICs 1/ Gross non-FDI inflows to GDP Latin America East Asia Net non-FDI inflows to GDP Source: Calderon and Servén 2013 9 Capital flows: why bother now? Historically the main source of volatility in Turkey has been cross border capital flows, why bother now? Size and volatility of capital flows have increased even more during the post-crisis period More importantly, it is mainly driven by global factors. • Less related to domestic fundemantals • Inefficient and distortionary 10 Emerging Market Currencies Against USD* 1.35 Collapse of Lehman Brothers 1.25 1.15 1.05 0.95 20%-80% Interval of EMs 0.85 EM Average 0911 0511 0111 0910 0510 0110 0909 0509 0109 0908 0508 0108 0907 0507 0107 0906 0506 0106 0905 0505 0105 0.75 Emerging Economies: Brazil, Chile, Colombia, Czech Republic, Hungary, Indonesia, Malaysia, Mexico, Philippines, Poland, Romania, South Africa, Korea. 11 Portfolio Flows: Turkey vs. Developing Countries (Billion US dollars) 13-week moving average 1.2 1.0 Turkey All developing countries (right axis) 6 5 0.8 4 0.6 3 0.4 2 0.2 1 0.0 0 -0.2 -1 -0.4 -2 -0.6 -3 Source: EPFR, CBRT. 12 Capital flows: challenges Capital flows may have important benefits, but they pose big challenges for macroeconomic policy as well: Sudden reversals (stops) can have very large adverse effects on real and/or financial sector. Procyclical flows amplify macro-financial fluctuations, rather than dampening them. 13 Amplifying Role of Cross Border Capital Flows Improvement in Global Risk Perceptions Capital Inflows 14 Amplifying Role of Cross Border Capital Flows Improvement in Global Risk Perceptions Capital Inflows Currency appreciation Balance sheet and collateral effects, rapid credit growth 15 Amplifying Role of Cross Border Capital Flows Improvement in Global Risk Perceptions Capital Inflows Currency appreciation External Borrowing Balance sheet and collateral effects, rapid credit growth 16 Amplifying Role of Cross Border Capital Flows Capital flows lead to an appreciation in currency, which improves the balance sheets of firms and increase collateral values. This leads to more credit growth, higher demand for nontradable goods and thus further appreciation. Rapid credit growth is financed by external borrowing, leading to further inflows. Pecuniary externalities: Overborrowing and overvaluation of currency Caballero and Krishnamurthy (2004), Lorenzoni (2008), Bianchi (2011), Bruno and Shin (2013). 17 Capital Flows, Credit , and Exchange Rate Cycles (HP filtered, standardized) 2 Loans (t) REER (t+2) Inflows (t+2) 1.5 1 0.5 0 -0.5 -1 -1.5 2013Q2 2012Q4 2012Q2 2011Q4 2011Q2 2010Q4 2010Q2 2009Q4 2009Q2 2008Q4 2008Q2 2007Q4 2007Q2 2006Q4 2006Q2 2005Q4 2005Q2 2004Q4 2004Q2 -2 Source: CBRT. 18 Capital Flows and Macrofinancial Risks: Turkish economy as of late 2010 19 Turkish Economy as of late 2010: Sharp Increase in the Current Account Deficit, Financed with Short-term Inflows Current Account Balance Main Sources of External Financing* (Seasonally Adjusted, Quarterly Average, Billion USD ) 2 (12-months Cumulative, Billion USD) 80 Portfolio and Short-Term* 1 FDI and Long-Term** 70 Current Account Deficit 0 60 -1 50 -2 40 -3 30 20 -4 CAB 10 -5 CAB (excluding energy) -6 0 -10 -7 Source: TURKSTAT, CBRT. 2011:01 2010:11 2010:09 2010:07 2010:05 2010:03 2011 2010:01 1 2009:11 2010 4 2009:09 3 2009:07 2 2009:05 1 2009:03 2009 4 2009:01 3 2008:11 2 2008:09 2008 1 2008:07 4 2008:05 3 2008:03 2 2008:01 1 2007:11 4 2007:09 -20 -8 *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. Source: CBRT. Turkish Economy as of late-2010: Rapid Credit Growth, and Sharp Appreciation of Domestic Currency Total Loan Growth Rates Real Exchange Rate (2003=100) (13 Weeks Moving Average, Annualized, FX Adjusted, Percent) 135 60 130 45 125 30 120 15 115 0 110 -15 105 Jul-10 May-10 Mar-10 Jan-10 Nov-09 Sep-09 Jul-09 May-09 100 0309 0409 0509 0609 0709 0809 0909 1009 1109 1209 0110 0210 0310 0410 0510 0610 0710 0810 0910 Source: CBRT Mar-09 Jan-09 Nov-08 -30 Searching for a new policy framework MAIN GOAL: Design a new framework to correct the cyclical part of the current account deficit, by reducing overborrowing and overvaluation, alleviate the impact of excessive volatility in capital flows on the domestic economy, reduce the sensitivity of credit and exchange rate cycles to capital flows, without jeopordazing price stability objective. 22 Can we do it with conventional Inflation Targeting? When global liquidity shocks dominate, using single instrument under IT may exacerbate the trade-offs For example, during capital inflows there are two options: • i↑ => further appreciation => wider CA deficit, sudden stop risks increase • i↓ => overheating => higher inflation Multiple objectives, multiple instruments are needed. 23 The New Policy Framework 24 Policy Framework Price Stability Policy Rate 25 Policy Framework Price Stability Price Stability Financial Stability Interest Rate Corridor Policy Rate Reserve Options Policy Rate, etc… 26 Financial Stability: How can Monetary Policy Contribute? Monetary policy can contribute to financial stability by reducing the probability of a sudden stop, and by dampening the amplification mechanisms triggered by capital flows. • smoothing credit and exchange rate cycles 27 Main Tools Policy Rate Interest Rate Corridor Liquidity Management Reserve Requirements Reserve Options Mechanism 28 Main Tools Policy Rate Interest Rate Corridor Liquidity Management Reserve Requirements Reserve Options Mechanism 29 Transmission Mechanism INSTRUMENTS Reserve Requirement Reserve Options Policy Rate Interest Rate Corridor Funding Strategy OBJECTIVES Macro prudential Policy Price Stability Interest Rate Policy Liquidity Policy Financial Stability 30 Transmission Mechanism INSTRUMENTS Reserve Requirement Reserve Options Policy Rate Interest Rate Corridor Funding Strategy OBJECTIVES Macro prudential Policy Interest Rate Policy Liquidity Policy Price Stability ? Financial Stability 31 Transmission Mechanism REFERENCE INDICATORS INSTRUMENTS Reserve Requirement Reserve Options Policy Rate Interest Rate Corridor Funding Strategy Macro prudential Policy Interest Rate Policy Liquidity Policy Credit Growth Exchange Rate OBJECTIVES Price Stability Financial Stability 32 The link between credit, exchange rate, and final objectives Smoothing credit and exchange rate cycles supports financial stability by dampening the leverage cycles and lowering the probability of a sudden stop, helps price stability through lower inflation volatility, given the high exchange rate pass-through in Turkey, and implies a more balanced growth path. 33 Exchange Rate, Credit, and Financial Stability Gourinchas and Obstfeld (2012): Two factors emerge as the most robust and significant predictors of financial crises: • rapid increase in leverage (credit growth) • sharp real appreciation of the currency. Schularick and Taylor (2012) Role of leverage (credit growth) in financial vulnerability 34 New Policy Tools 35 How to limit the adverse impact of capital flow volatility? Need to dampen the credit and exchange rate cycles. Two ways to implement this goal: 1. Reduce the volatility of capital flows Main Tool: Asymmetric Interest Rate Corridor 2. Weaken the link between flows and the economy Main Tool: Reserve Options Mechanism 36 Asymmetric Interest Rate Corridor 37 Operational Framework Under Inflation Targeting Late Liquidity Lending Rate Interest Rate Corridor O/N Lending Rate O/N Lending Rate to Market Makers CBT Policy Rate (One Week Repo) Secondary Market Interest Rate O/N Borrowing Rate Late Liquidity Borrowing Rate 10:00 11:00 Interbank + OMO 16:00 17:00 Hours Late Liquidity Window 38 Operational Framework Under Conventional IT (Simplified) CBT Lending Rate CBT Policy Rate (One Week Repo Rate) CBT Borrowing Rate Secondary Market Interest Rate 39 Corridor as a policy tool during the risk-off mode CBT Lending Rate CBT Policy Rate (One Week Repo Rate) CBT Borrowing Rate Secondary Market Interest Rate 40 Capital Outflows (Risk off) CBT Lending Rate Secondary Market Interest Rate CBT Policy Rate (One Week Repo Rate) CBT Borrowing Rate 41 Capital Inflows (Risk on) CBT Lending Rate CBT Policy Rate (One Week Repo Rate) Secondary Market Interest Rate CBT Borrowing Rate 42 Monetary Policy Interest Rate Corridor and Average Funding Rate 20 (Percent) Lehman Crisis QE2 Eurozone Debt Crisis OMT 18 16 Adoption of 1-week repo rate as the policy rate 14 12 10 8 6 O/N Lending - Borrowing Interest Rate Corridor 4 1-week Repo Rate 2 BIST O/N Rate (10-day MA) Average Funding Rate 0 Source: BIST, CBRT. 43 Capital Flows and Exchange Rate Volatility e = TL / $ Supply of $ σe Demand for $ Quantity of $ 44 What Does Interest Rate Corridor Do? e = TL / $ Supply of $ σe σ'e Demand for $ Quantity of $ 45 Relative Exchange Rates TL and Other Emerging Market Currencies vs USD (01.11.2010=1) 1.40 20%-80% Interval of EMs EM Average New Policy Mix and Cutting the Lower Bound of the corridor 1.30 Turkey 1.20 1.10 1.00 Source: Bloomberg. 05/13 03/13 01/13 11/12 09/12 07/12 05/12 03/12 01/12 11/11 09/11 07/11 05/11 03/11 01/11 11/10 09/10 07/10 0.90 Last Observation: June 10, 2013. Emerging economies include Brazil, Chile, Colombia, Czech Republic, Hungary, India, Indonesia, Israel, Malaysia, Mexico, Philippines, Poland, Romania, South Africa, South Korea and Thailand. 46 Reserve Options Mechanism (ROM) 47 Definition of ROM ROM is a mechanism that provides the banks the option to hold a certain fraction of their TL RRs in FX and/or gold. ROM provides incentives for the banks to accumulate reserves in good times to use in bad times. To what extent the banks will use ROM will depend on the relative cost of using and not using the facility • The CBRT can change this cost through Reserve Option Coefficients (ROC) • The cost will also depend on relative interest rates on FX vs TL funding 48 Threshold ROC For each bank, there is a “threshold ROC” (ROCtr ) that makes the bank indifferent between using and not using the facility. This level will depend on the relative cost of FX vs TL funding: 𝑹𝑶𝑪𝒕𝒓 where, 𝒓𝒕 𝑻𝑳 = 𝑬 𝒆𝒕+𝟏 𝒓𝒕 𝑭𝑿 ∗ 𝒆𝒕 𝑟𝑡 𝑇𝐿 : cost of TL funding, 𝑟𝑡 𝐹𝑋 : cost of FX funding 𝑒𝑡 : spot exchange rate at the beginning of the maintenance period 𝐸 𝑒𝑡+1 : expected exchange rate for the end of the maint. period. 49 Reserve Option Mechanism: Automatic Stabilizer Reserve Option Coefficients (ROC) Threshold ROC A Effective Utilization Ratio Upper Limit for holding RR in FX 50 Reserve Option Mechanism: Automatic Stabilizer Reserve Option Coefficients (ROC) Threshold ROC’ Threshold ROC A’ A Effective Utilization Ratio Upper Limit for holding RR in FX 51 03/13 03/13 02/13 01/13 01/13 12/12 11/12 11/12 10/12 09/12 08/12 08/12 07/12 06/12 06/12 05/12 04/12 04/12 03/12 02/12 02/12 01/12 12/11 12/11 11/11 10/11 09/11 FX Reserves Accumulated through ROM FX Reserves Maintained by Banks under ROM (Billion USD) 35 30 25 20 15 10 5 0 52 Benefits of ROM Automatic stabilizer: dampens the impact of capital flow volatility on domestic macroeconomic variables Weakens the adverse feedback loop between capital flows, exchange rate, and bank lending Helps to build up reserves Less sterilization costs than FX intervention Market friendly and efficient mechanism 53 An illustration of the interaction between, capital flows, credit, and exchange rate: The role of ROM 54 Amplifying Role of Cross Border Capital Flows Improvement in Global Risk Perceptions Capital Inflows Currency appreciation External Borrowing Balance sheet and collateral effects, rapid credit growth 55 Exchange Rate is a function of credit (C) and risk premium (rp) Credit E(C;rp) 0 0 Exchange Rate Appreciation 56 At the same time credit is a function of exchange rate Credit C(E) E(C;rp) 0 0 Exchange Rate Appreciation 57 Suppose initially the economy is at high exchange rate low credit state Credit C(E) C a E(C;rp) 0 0 Appreciation E Exchange Rate 58 A sudden improvement in the risk appetite… Credit falling risk premium C(E) C a E(C;rp) E(C;rp') 0 0 Appreciation E Exchange Rate 59 May start a chain reaction… Credit falling risk premium C(E) C a E(C;rp) E(C;rp') 0 0 Appreciation E Exchange Rate 60 And shift the economy to a low exchange rate high credit state Credit C(E) C' The impact of falling risk premium a' C a E(C;rp) E(C;rp') 0 0 E' Appreciation E Exchange Rate 61 Yet, the final impact would be more limited with ROM Credit C(E) C' The impact of falling risk premium a' C′′ The impact of falling risk premium under ROM a′′ C a E(C;rp) E(C;rp') 0 0 E' E′′ Appreciation E Exchange Rate 62 Have new instruments weakened the impact of capital flows to domestic macroeconomic variables? 63 Current Account and Capital Flows Current Account Deficit and Net Capital Inflows (12 Month Cumulative, Billion USD) 90 CAD 80 Net Capital Inflows 70 60 50 40 30 20 10 0 Source: CBRT. 01/13 11/12 09/12 07/12 05/12 03/12 01/12 11/11 09/11 07/11 05/11 03/11 01/11 11/10 09/10 07/10 05/10 03/10 01/10 11/09 09/09 07/09 05/09 03/09 01/09 11/08 09/08 07/08 05/08 03/08 01/08 11/07 09/07 07/07 05/07 03/07 01/07 -10 Last Observation: February 2013. 64 Volatility of the Turkish lira and other EM currencies against USD (30 days moving average) New Policy Instruments 1.9 1.7 Other EM Currencies 1.5 Turkish lira 1.3 1.1 0.9 0.7 0.5 0.3 0113 1112 0912 0712 0512 0312 0112 1111 0911 0711 0511 0311 0111 1110 0910 0710 0.1 * Countries with current account deficits are Brazil, Chile, Columbia, Czech Republic, Hungary, Indonesia, Mexico, Poland, Romania, South Africa, and Turkey. 65 Curtosis of the Implied Distribution of Turkish lira and other EM Currencies against USD (30 days moving average) * The shaded area denotes the maximum and minimum of the Kurtosis of FX expectations for 10 emerging economies with current account deficits. Source: Değerli and Fendoğlu (2013) 66 Source: CBRT. Last Observation: May 2013. 67 04/13 01/13 10/12 07/12 04/12 01/12 10/11 07/11 04/11 01/11 10/10 07/10 04/10 9 01/10 10 10/09 07/09 04/09 01/09 10/08 07/08 04/08 01/08 10/07 07/07 04/07 01/07 10/06 07/06 04/06 Inflation Expectations Adoption of New Policy Framework 8 12 months 7 6 24 months 5 4 3 2 Conclusion Heightened volatility in cross-border flows have prompted Central Bank of Turkey (CBT) to change its policy framework by incorporating financial stability into the inflation targeting regime. The new policy set-up and the tools developed by the CBT have eased the trade-offs posed by cross border capital flows. Turkish way of dealing with capital flows may setup a useful example for other emerging economies. 68 Capital Flows, Financial Stability, and Monetary Policy Hakan Kara Central Bank of Turkey Anadolu International Conference in Economics June 19, 2013, Eskişehir