The political authority must introduce measures discouraging short term capital inflows.

What was the main problem of the currently implemented monetary policy? The problem was that it aimed to reduce the volume of funds that banks can extend as credits in order to limit the rapid credit expansion on the one hand, and transferred funds with weekly maturity to banks in order to keep the policy rate around the targeted level.

Deposits that form a substantial proportion of the funds collected at the hand of banks are short term funds. Therefore for banks there is no difference between the deposits they collect and the funds they borrow from the Central Bank (CBT). They can extend credits also using the funds borrowed from the CBT. Thus it is quite unlikely that the CBT fulfill its target to limit the volume of funds that can be extended for credits.

This possibility become 'likely' only under one condition: If banks do not know for sure whether they can borrow from the CBT also in the next week, they cannot extend credits with longer maturity relying on the CBT funds of one-week maturity. Can the CBT introduce such a uncertain climate?

The BRSA might step in
The answer to this question would be no because to be able to stop lending to banks or limit the amount borrowable, the CBT has to allow interest rates to move up. However this contradicts with both the actions to reduce the interest rate and the will to discourage short term foreign capital inflows. This therefore is a dead-end road. Then comes to the fore a critical question: At this point on, what can the CBT do to increase the chances of the policy's success or at least overcome the mentioned contractions?

At this point the BRSA (Bank Regulation and Supervision Agency) must step in. Should the design measures that will prevent banks from extending credits using the one-week maturity funds borrowed from the CBT, the contradiction created by the CBT's policy initiative would be eliminated. Then, if the BRSA steps in and designs and implements such mechanism, will be CBT succeed in its target to limit credit expansion, in particular that created by short term foreign fund inflows?

Banks can pursue credit expansion despite the rise in the required reserves at any level as long as they can borrow easily from abroad. There are two ways to block this channel: First, the BRSA can make it costlier to extend credits with short term foreign funds. Second, the political authority imposes a tax directly on short term foreign capital inflows.

Corporate sector borrowing cannot be prevented
With any perspective the second policy option seems to be wiser. First, it saves the CBT from pushing hard to break our routine. Second, the risk that domestic financial markets become shallow as a side effect of the same routine breaking policies will be eliminated. In short, you punish short term foreign capital inflows instead of domestic banks. Third, even the BRSA steps in and follows the said path, you cannot stop the corporate sector borrowing short term funds from abroad. However the decision by the political authority would reduce such borrowing possibilities also.

In short, if the target genuinely is to prevent short term fund inflows and the resultant expansion in credit volume, the political authority must introduce measures discouraging short term capital inflows as currently seen in a number of developing countries like Turkey.

This commentary was published in Radikal daily on 03.02.2011