The decisions of the CBT are not contradictory.

Again chaos is about to erupt. Global risk appetite decreased sharply in the last two days. European and US stocks markets dropped harshly. This increased the demand for German and US bonds, which are seen as the most reliable financial asset in such milieus, and thus reduced their returns. On the other hand, interest rate on many European countries increased due to the fall in demand for their assets.

The Central Bank of Turkey (CBT) Monetary Policy Council (MPC) made a series of decisions in the extraordinary meeting on last Thursday. The decisions came as a shock to markets. On Friday morning while I was writing these lines, economics news channels were trying to understand rather than discuss the decisions. Some points must be highlighted in order to understand why they are confused.

1) Until recently both the government and the CBT was complaining about high current account deficit, high short term capital inflows and rapid credit expansion. Due to these, the CBT had introduced a number of decisions beginning in November 2010 and the Banking Regulation and Supervision Agency (BRSA) had stepped in after the general elections. In a speech last week, the CBT President reiterated that it is of importance for the CBT to slowdown the rapid credit expansion.

2) During the same speech the President said, "We stated previously that we might gradually narrow the interest rate corridor in the case that concerns about the public debt problems of some European countries and about global growth continue to affect the risk appetite negatively. Moreover, I would like to stress that if that the problems of the developed countries intensify and that the domestic economic activities slowdown, we might have to use all policy tools for an expansionary policy attempt."

3) On Thursday the CBT not only narrowed the interest rate corridor but also reduced the policy interest. In other words, the CBT believes that the problems of the developed countries of Europe intensified slowing down domestic economic activities and affected negatively the global risk appetite.

In this light, the underlying cause of confusion after the MPC meeting was the fact that the CBT that until then complained about and devoted efforts towards rapid credit expansion and high current account deficit introduced anti-recessionary measures. The previous complaints about rapid credit expansion and the deterioration of the current account deficit were interpreted as complaints about growth over the potential. Therefore, they started to question how a rapidly growing economy could come to the brink of economic recession in such a short time.

The decisions are not contradictory

However, the CBT decisions are by no means contradictory. Please note that I am not discussing whether or not the decisions were correct. I am just examining the consistency between the CBT decisions and actions. I believe that the commentators neglect some important details:

1) The CBT has always argued that national income is currently below the potential. This can be seen in President Başçı's last week. In this sense, it is not possible to conclude that the economy has overheated. Therefore, for the CBT, the main problem of the economy is not growth above potential.

2) The underlying reason for the concerns about rapid credit expansion is that this movement was enabled by low-interest policy of developed countries as well as injection of unprecedented amounts of liquidity into markets. The liquidity seeks a market to flow in and ends up in developing countries like Turkey.

3) The said liquidity is short term and it has the potential to return to the mother country immediately following a significant increase in global risk perception in the case of which the sectors that borrowed at high amounts will face difficulties. They will be asked to repay their debt and they will cut expenditures (to reduce production and investments with the case for the corporate sector) to repay it. This has the potential to damage financial stability since some sectors might face difficulty in repaying credits.

4) In that case, national income, which the CBT already considers to be below the potential, might go further below the potential level. Also given that more than half of Turkey's exports go to Europe, the CBT sees a severe risk of recession. Let me repeat: this recession might also harm financial stability. Thus, the bank reduced the interest on weekly borrowing.

5) On the other hand, exchange rate increased substantially due to the previous policies of the CBT while the President implied last week that the level of the exchange rate then was sufficient. The CBT thinks that under the current circumstances, exchange rate might increase further. This is why they initiated FX sale auctions and reduced the reserve requirements for FX to relieve the banking sector.

6) Banks have to pay the CBT's interest rate on borrowing if they want to sell overnight liquidity to the CBT. This rate sets the lower threshold of the corridor. The CBT increased this rate from 1.5 to 5 percent. In a way, the CBT wants to discourage the outflow of short term capital because an upwards pressure will be put on the exchange rate, otherwise. The conclusion: Since November 2010, the CBT has been considering that financial stability was under threat. It introduced a number of decisions that it believed will eliminate the threat. The decisions announced on Thursday were also targeted at securing financial stability.

And a footnote: If the interpretations and comments that aim to understand the CBT's motivation are sincere, then there is a problem with the CBT's communication policy. Confusion would have been less if the CBT explained the framework of the actions concerning financial stability.

This commentary was published in Radikal daily on 06.08.2011