Scenes From A Central Bank: A Turkish Tale in Two Acts

IMF Blog, April 2, 2013

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Authors: Robert Tchaidze, Heiko Hesse
Date: April 2, 2013
Context: In mid 2010 the Turkish central bank introduced a policy that increased uncertainty in interest rates to deter speculative foreign capital inflows amid an overheating economy characterized by a lending boom, an appreciating exchange rate, and a widening current account deficit.
Notable recognition: Central bank governor Erdem Başçi received the 2013 “Banker of the Year” award from the Financial Times’ The Banker magazine.

Objective shift: Although formally targeting inflation, the central bank became increasingly vocal about financial stability risks and began using less traditional tools explicitly to address both price and financial stability.
Interest rate corridor adjustments:
- In October 2010 the central bank sharply lowered the overnight borrowing rate while keeping the overnight lending rate unchanged, widening the interest rate corridor.
- The corridor became a signaling device; the “floor” signaled a guaranteed rate-of-return, and lowering it was intended to deter speculative inflows.
- Liquidity provision was varied via repo auctions, generating volatility in the overnight interbank rate.
Required reserve ratio measures:
- The central bank stopped remunerating reserves, increased required reserve ratios, and differentiated them by maturity.
- Purpose: act as both a monetary policy instrument and a macroprudential tool to lower systemic risks from excessive credit growth and make short-term funding more expensive.
Timing of broader measures:
- Lending started to slow only in the second half of 2011 after:
- In June 2011 the banking supervisor introduced macroprudential measures that made consumer loans costlier;
- The central bank publicly expressed its preference for a 25 percent credit growth; and
- External conditions began to worsen.

Shift in late 2011 due to weakening capital inflows:
- Lira depreciation pushed inflation to 10.4 percent.
- The current account deficit rose to 10 percent of GDP, the second highest in the world in dollar terms.
Policy reversals and new tools:
- By late December the central bank increased both the overnight and lending rates, sold foreign exchange reserves, and lowered required reserve ratios.
- It provided liquidity through different repo facilities:
- Quantity auctions at the policy interest rate.
- Price auctions with interest rates determined by the market.
- Varying liquidity through these facilities allowed daily changes in the effective cost of lending to banks—tightening when needed and loosening when the domestic economy required support.
- The central bank stopped active foreign exchange market operations and instead allowed banks to convert part of their required reserves on lira liabilities into foreign exchange and gold via the Reserve Option Mechanism (ROM), aiming to let market forces determine the exchange rate while mitigating volatile capital flow pressures.
Resulting 2012 outcomes (soft landing):
- Economy grew 2.2 percent.
- Current account deficit narrowed by some 4 percentage points of GDP.
- Inflation ended at 6.2 percent.
- Contrast noted with downturns in 2001 and 2009 when adjustments in the current account deficit were accompanied by significant declines in economic output.

Policy coordination is crucial:
- Earlier action by the banking supervisor (e.g., macroprudential measures before June 2011) could have reduced financial risks, reduced pressure on the central bank, and allowed the central bank to concentrate on controlling inflation.
Complexity and communication costs:
- Complex approaches with multiple objectives and tools, combined with unclear messaging, can confuse market participants and weaken the transmission of monetary policy to inflation expectations and market interest rates.
- The experiment showed that uncertainty in overnight interbank rates did not lead to a decline in other yields as had been hoped.
Liquidity is decisive:
- It is the amount of liquidity that matters, not the specific instruments the central bank uses. When cumulative injection of liquidity peaked, inflation rose and the currency weakened; when liquidity was tightened, the currency stabilized and inflation started to decrease.
Final assessment:
- Turkey’s navigation to a soft landing and receiving an investment grade from Fitch in 2012 was an important vote of confidence, but the experience underscores that lack of coordination and clear communication can undermine policy success.

Source: Scenes From A Central Bank: A Turkish Tale in Two Acts — Robert Tchaidze, Heiko Hesse, April 2, 2013.