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The Kapali Carsi

The lira and Central Bank of Turkey’s options

I was planning to write this much earlier, but I learned that the release requests for Besiktas manager Tayfur Havutcu and director of football operations Serdal Adali were denied. That left me quite a bit devastated, as they are being held without any solid evidence of any wrongdoing. But then again KSG professor Dani Rodrik’s father-in-law is also in jail on made-up evidence for planning a coup (the sham Sledgehammer trial) that Rodrik has documented over at his blog. Anyway, I already wrote my thoughts 10 days ago, so no need to repeat them again, but if you would like to ask me on that, do send me an email or write a comment on the blog, and I will respond as soon as I can.

Anyway, coming back to the matter at hand, The Central Bank of Turkey, or CBT, halted FX buying auctions as well as as decrease required reserve ratios, or RRRs, on long-term foreign currency deposits. The former measure will leave USD 30mn of FX in the market, whereas the latter will add USD 590mn FX liquidity once it comes to effect on August 5. The latter measure created some confusion in markets, and I got a couple of reader questions on whether the RRR decreases contradicted earlier hikes, which were designed to slow down the economy. Well, again, the goal here is to provide FX liquidity and therefore slow down lira depreciation.

Considering the May current account deficit was USD 7.8bn, you could argue that these measures are largely symbolic. And in fact, they only held the weakening in the lira for a while on Monday. But they are signaling that the CBT is not totally ignorant of the lira depreciation, which was more and more becoming the consensus view of the markets. Besides, other EMs did not do well on Monday, either, mainly because of U.S. debt ceiling worries.

Going forward, the Central Bank does not really have many real options. I see rate hikes as the final option, only as a response to a very sharp depreciation, as in 2006 (BTW, David Rogovic of Roubini Global Economics has a very good comparison of the 2006 episode and now). Similarly, FX selling auctions and discretionary FX intervention, a la 2006, are last-resort weapons as well, to be utilized before a rate hike; while not exactly pocket money, reserves are dwarfed by the country’s external financing requirement. In fact, I don’t think the Bank would go for more RRR decreases, either, as it would not make sense from a macroprudential point of view.

I think the next step for the Central Bank would be to narrow the interest rate corridor around the repo policy rate, as it has been saying it would. This would be done by increasing the borrowing rate of 1.5 percent. Although this floor does not matter in practice because the overnight is well above it, it would decrease the volatility of the overnight and therefore induce carry trades, exactly the kind of flows the Bank enacted these measures in the first place late last year to avoid:). The vicissitudes of fate, as V would day

Another option would be to to reduce the weekly auctions at the policy rate of 6.25 percent. One rather handy byproduct of the Bank’s unconditional policy mix is that the Turkish market has become very dependent on Central Bank liquidity, so you would see an immediate impact on overnight rates of such a move.

But then the Bank would need to increase the ceiling of the interest corridor, i.e. the lending rate. While it is 9 percent, it is 8 percent for primary dealers, making the latter level the effective ceiling. And at 7-7.5 percent, we are not that far away from that level. Besides, the Bank could start reducing liquidity through auctions right away, while it would have to wait until the next MPC meeting in 3 weeks to narrow the corridor- it could in theory call a special meeting as in 2006, but they woulnd’t want to do that if things got really out of control.

Speaking of that, can things get out of control? One important signal to follow will be the behavior of Turkish FX retail accounts. These usually sell when the lira depreciates, acting as a buffer against further depreciation.

If these guys decide to buy FX while the lira is depreciating, meaning they expect even more depreciation, then it is Hail Mary time. Official data on FX retail deposits lags by two weeks, so I don’t have data to support this, but bank economists are saying, hopefully after having spoken with teir Treasury or retail departments, that there isn’t retail FX buying yet. Which tells us the selling is mainly coming from foreigners,which could be seen from banks’ off-balance sheet positions, but these are trailing by two weeks as well.

But a recent Bloomberg article is reporting that, based on options postions, foreigners are still shorting the lira (HT to Atilla Yesilada), so we are definitely not out of the woods yet. Far from it…

As for other Turkish assets,I would not make too much out of the increase in Istanbul Stock Exchange for the past two days. For one thing, the ISE was recuperating losses of late last week:

Besides, ISE is dominated by bank stocks, and RRR cuts might have been interpreted as bank-positive. Moreover, foreign ownership is at historic lows, which is somewhat supportive:

But in a longer perspective, the measures I am describing are definitely not very equity-positive, as local rates are bound to go up. And that includes Treasuries, my dear friends, which looked so cheap a few weeks ago. Yet again the vicissitudes of fate, I guess:)…

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