Turkish monetary policy: Whatever works

There are two faucets and a drain in a pool. One of the faucets can fill the pool in two hours, the other in five. The drain can empty the pool in four hours. How long will it take for the pool to fill up if it is one third full to start with? 

I was completely “conpuzzled” by these problems at primary school. Not that I was bad at math, but I just couldn’t figure out why anyone in her right mind would not plug the drains if she wanted to fill up the pool in the first place.   

After all these years, I am faced with the same problem again. The Central Bank of Turkey has been selling its foreign exchange reserves to protect the lira, but then coming up with ingenious schemes to collect them. For example, it is allowing banks -- the very ones to which it has been selling this foreign currency -- to maintain their lira required reserves at the Bank in foreign currency.

With dollars being filled and drained at the same time, it isn’t a big surprise that this method has not been very effective. The Bank sold about $1.5 billion on Tuesday, of which $750 million was the daily auction and the rest the Bank’s first direct intervention since 2006. However, by the end of the day, the lira had barely moved. 

Since increasing the supply of foreign currency has not worked, the Bank has now turned to domestic currency. By raising the overnight lending rate from 9 to 12.5 percent (8 to 12 percent for primary dealers) at Thursday’s rates meeting, the Bank has provided itself the necessary room to squeeze lira liquidity.
The resulting higher overnight rate will, in turn, make it more expensive to short the lira. Since the borrowing rate was kept at 5 percent, the wider window has increased volatility as well, which would further deter speculative flows. However, if the Central Bank is aiming to strengthen the lira with the familiar supply-demand mechanism, it may not have as much luck.
While banks are extremely dependent on the Central Bank for liquidity, they may respond to a liquidity squeeze by selling off their government bonds. The result would be a bloodbath in the short end of the yield curve rather than a stronger lira.

But if tightening domestic liquidity doesn’t work, the Bank is likely to pull other tricks out of its hat, as Central Bank Gov. Erdem Başçı has recently hinted. This line of thinking is reminiscent of Nasreddin Hodja trying to ferment the Akşehir Lake with a cup of yoghurt. 

By telling the doubters “what if it works”, the wise Hodja is noting his extremely asymmetric cost-benefit structure: If the fermenting doesn’t work, he will lose only his cup of yoghurt, but if it does, he’ll have a lake of yoghurt. 

Unfortunately, the Central Bank does not have that luxury. It needs reserves for the real tough times, in case the Euro Area goes bust, and banks’ higher funding costs will be reflected in credit rates, exacerbating the slowdown in economic activity.  

Luckily, the Bank finally adopted a hawkish tone with regard to inflation in its one-pager accompanying the rates decision. If they continue in this vein in this week's Inflation Report and next week's monthly meeting with economists, they could help the lira for once