Under the floating exchange rate regime, the exchange rate is expected to float. If it does not, the banking system that cannot sense risk accumulates risks.

The world economy is going through an unprecedented period. Surrounded by events with which we are unfamiliar, central banks too are acting in new ways. The Central Bank of Turkey (CBT)  has been acting outside of the box for some time now. Most recently, it has introduced the Reserve Option Mechanism (ROM), which has brought remarkable stability in foreign exchange (FX) markets. With ROM, a significant proportion of the transactions in FX markets has been excluded from the price setting process. The first question to ask here is: is Turkey still employing the free-floating exchange rate regime? Second, would this policy have a side effect? Let me tell you what I think.

Banks collect deposits from their customers and, in turn, extend loans. They turn deposits into credits. When doing this, they undertake risks using their customers’ deposits. In order to limit that risk, the state asks banks to keep a certain proportion of the deposits in a safe haven, the central bank, in the form of reserve requirement. This way, the state provides a guarantee for people’s deposits and people, trusting this guarantee, deposit their money in the banks. This is how the system works.

Along with the ROM, the CBT declared that banks are allowed to keep a certain proportion of reserve requirements on deposits in FX and in gold. The proportions that can be kept in FX and in gold are determined separately. For the time being, banks are allowed to keep up to 90 percent of reserve requirements in FX. FX to be kept as reserve requirement is deposited in the CBT at the current exchange rate. This FX supply is not separately accounted for in the exchange rate setting process, but it directly pushes up the FX reserves of the country.

Within this picture, the first point to state is that the mechanism is not a disturbance for anyone. Banks choose to keep reserve requirements in FX as long as it is cheaper. As the FX inflows do not go into circulation in the market, the option prevents the lira’s appreciation and in a way stabilizes the exchange rate. This pleases both exporters and the Ministry of Economics. Meanwhile, as the FX reserves of Turkey appear to have increased, this pleases the prime minister, too.

As Alper-Kara-Yörükoğlu (2012) state, the ROM works as a sort of automatic stabilizer. The exchange rate volatility caused by the inflow of dollars and euros that the countries of the center issued in order to tackle the crisis is averted this way. Yet, this has turned the Turkish economy into an artificial paradise.

So, what is the problem if everyone is content? Let me tell you: thanks to the ROM, the FX inflows used to meet reserve requirements don’t affect the exchange rate by its nature. Normally, if the FX supply outgrows the FX demand, the lira appreciates. With the ROM, however, the exchange rate does not completely reflect the changes in the FX supply, by definition.

If, due this regulation, changes in quantity will not be translated into price changes, the risk perception of some banks will eventually become confused. The volatility of the exchange rate is evidence of the rising exchange rate risk. Under the floating exchange rate regime, the exchange rate is expected to float. If it does not, the banking system fails to sense this and thus accumulates risks.

So, let’s answer the questions above: 1. No, 2. Yes.

The last time Turkey concentrated on quantity adjustment rather than on price adjustment, we suffered severe consequences. Let me remind you on this occasion.

This commentary was published in Radikal daily on 02.11.2012