If the BRSA steps in and introduces regulations that will discourage extending credits using short term funds, the CBT's chances to succeed with the new policy framework will be increased.

I have written a number of commentaries on the latest decisions of the Central Bank of Turkey (CBT). I want to wrap up my comments so far. Today I want to stress three important points about the series of decisions of the CBT to increase the required reserve ratio with the aim to slowdown the rapid rise in the credit volume.

First point:  The CBT has broken the routine with the latest series of decisions. It went beyond the inflation targeting regime that has been implemented explicitly or implicitly since 2002. The main justification was that under the current circumstances, an interest rate policy in harmony with the objective of financial stability might be tighter than that required by the objective of price stability. Therefore, the CBT chose to increase the required reserve ratio instead of interest rates so that the rapid credit expansion does not threaten financial stability. So, it employed another policy tool in addition to the main policy tool of short term interest rate. This is one of the key issues addressed in the context of the monetary policy debates across the world. Then how can we add the objective of financial stability into the frame of inflation targeting regime?

The CBT took risk and introduced a new policy implementation framework

In response to the problem that demonstrated a tendency to grow, the CBT took risk and searched for a new policy implementation framework. There is no sense in seeking another justification. This is why I have written commentaries refuting such implications.

The second point: The CBT is faced with a dilemma that can possibly be overcome. In order to keep the repurchase rate, the main policy tool for inflation targeting regime, at the desired level, the CBT has to meet the liquidity requirement of the banks. However, in the context of the financial stability objective, it has been withdrawing liquidity from the system by increasing the required reserve ratio. Three preconditions must be met to overcome this contradiction.

The CBT provides two-week maturity liquidity to banks via repurchase auctions. Average maturity of the liquidity withdrawn due to the rise in the required reserve ratio is equal to the average maturity of banks' deposits and similar liabilities. If the difference was large, banks would not have increased the amount of weekly borrowing to compensate for the loss of liquidity and to maintain the initial credit supply. But the difference between the two maturities is not very large. So the first precondition is not met (This is what the figures announced so far reveal). 

The BRSA might step in with additional regulations

In that case the CBT has to increase the required reserve ratio to a level that will make banks refrain from the impact on the balance sheet of compensating for the loss of liquidity via one-week borrowing and thus reduce the credit supply. Extreme case: if you increase the required reserve ratio to 100%, there will be no credit supply at all. Therefore, you have to set the required reserve ratio at a level that will make banks refrain from compensating the loss of liquidity and thus cut down the increase in the credit supply.

There is an easier way than trying to meet this precondition: The Banking Regulation and Supervision Agency (BRSA) steps in and introduces regulations that will discourage extending credits using short term funds. Should this third precondition is met, the CBT's chances to succeed with the new policy framework will be increased.

The third point: Never initiate an action the justification of which cannot be explained clearly. The CBT had increased twice the required reserve ratio and decreased the repurchase rate at the same time. It was not easy to explain the justification for this policy choice in the face of the suspects about the feasibility of the inflation target. The justification was not understood, indeed. This was why some comments made certain implications.

Now it is time to examine the declarations of the CBT about the steps taken to discourage short term capital inflows and the dissuasiveness of the decisions. I will deal with this in the next commentary...

This commentary was published in Radikal daily on 15.03.2011