Download Capital Flows, Financial Stability, and Monetary Policy Hakan Kara

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