It is evident that raising reserve requirements do not push up the costs for banks. It is time to develop a new theory.

Every dance ends. This is how I respond to those who ask me what I think about the unusual monetary policy of the Central Bank of Turkey (CBT). Recently in Washington, a friend at the heart of the international financial community asked me, "Do you still remember how to dance the Twist?" The subject of the conversation of the unusual monetary policy framework the CBT initiated in the late 2010. At first, I was like, "What are you talking about?" He said, "The Twist is an outdated dance from the 1960s. In my opinion, your Central Bank still does the Twist." The CBT tries to fake the markets with some attractions. This made sense yesterday. But if people start to think "this is only the Twist; they are trying to pull the wool over our eyes," the circumstances must be reviewed. Let me explain why.

Since December 2010, the CBT has declared a series of unprecedented measures. It has reduced the interest on the overnight borrowing of foreign exchange on the one hand, and increased reserve requirements to struggle for rapid credit expansion, on the other. Meanwhile, it has started to fund the markets at a fixed interest rate via open market operations (OMO). The objective of the first measure was to slow down the short term foreign fund inflows. The second measure aimed to force banks to increase interest rates due to the rise in their resource costs and thus limit the volume of credits they sell. The first measure has served the purpose while the second has not. But if nothing else, it confused people. I remember writing back then that "confusion" was beneficial. This was why I referred to the concept of "constructive ambiguity" in the international relations literature. Back then, it was useful to raise a number of question marks in people's minds. But now the Twist has ended.

At this point, the first question to ask is why the CBT needed the Twist in the first place. The reason is quite simple: Turkey's economy was recovering from the crisis at an uncontrolled pace. The economic administration did not take the necessary measures to cool down the economy in June 2010. Instead, a loose fiscal policy was maintained. As the elections were on the way, they had no intention to tighten the fiscal policy, either. The elections eliminated the chances for structural measures. Thus, the constructive ambiguity strategy of the CBT made sense. It was wise to raise question marks and make financial institutions assess their balance sheet positions twice. At least, this was what I though. This is exactly why I said, "let's wait and see." I am still at that point; I do not think what I argued was wrong. If so, I would admit it. To err is human. Recouping from error is a virtue. This is the first point.

And the second one: while pretending to increase the cost of extending credits for banks through reserve requirements, the CBT simultaneously started to fund banks at fixed interest through OMO. It demolished what it had built. It increased costs, on the one hand, and eased the cost burden of banks via short term funds at fixed interest, on the other. What happened in the end? The amount of funds provided by the CBT cumulatively increased day by day. A cumulative increase in OMO implies that the interest rate adjustment was prevented. When interest rate was fixed with administrative decisions, overnight funds turned into reliable and fixed rate six-month funds. The total amount exceeded 70 billion TL, 10% of the current deposit volume. It is dangerous to extend ten-year loans using overnight funds. It is like addicting banks to morphine. We saw this movie at the end of the 1990s. Then the banking crisis came in 2000-2001. So let this be the second point.

The third point is that banks ensured access to liquidity by selling government debt securities. In this way, they overcame the reserve requirement constraint. Credit volume could not be decreased but increased. The rise in reserve requirements proved futile. What is worse, everyone is now aware of this.

It is evident that raising reserve requirements do not push up the costs for banks. It would be wise not to overdo the twist and not to try to build an entirely new theory on a joke. The system is already prepared for increases in the interest rate. This is what I see.

This commentary was published in Radikal Daily on 17.06.2011