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Would it be better if the CB did not increase the rate?
Raising interest rate might prevent an excessive increase in the exchange rate. But at the end of the day, you cannot escape your fate.
The Central Bank Monetary Policy Committee’s (MPC) decisions in its yesterday meeting and the previous meeting are closely related to Turkey’s low savings rate. Since the domestic savings rate is extremely low, you have to borrow from abroad so as to achieve a certain level of investment. Turkey’s savings rate is low for a long time; this is not a recent phenomenon. It is only that the savings rate has decreased further to a lowest-low recently.
This phenomenon has a critical and highly negative outcome: the difference between Turkey’s FX liabilities and FX earnings widens in time in favor of the former. The difference, that is, the FX open position, was 53 percent in proportion to GDP as of the end of 2012. Turkey is the worst performer among the developing G-20 countries. For instance, the open position to GDP ratio in Mexico, second to Turkey, is 42 percent. Moreover, Turkey’s FX open position moved up in the first five months of 2013.
Balance sheets disturbed
Concerning monetary policy, 70 percent of the open position belongs to the corporate sector. The exchange rate exceeding a certain threshold especially within a short time frame affects the corporate sector adversely and disturbs balance sheets. This immediately hinders private sector investments and later on reduces production and employment. It also has an inflationary effect.
The Central Bank (CB) therefore seeks to prevent “extreme” hikes in exchange rate. The pace of the increase too is important, and vice versa: the Bank wants to prevent sharp falls in the rate (the appreciation of the lira) as well. This not only reduces Turkey’s competitiveness but also threatens financial stability as the fall in the exchange rate is accompanied with a rapid credit growth.
If you have read so far, you might get the idea that I suggest that the CB prevents extreme rises or sharp decreases in the exchange rate. That’s not the case, however. Given the fact that capital inflows (foreign debt) to Turkey and to peer economies are predominantly short-term, each and every development that pushes up interest rates in developed countries give way to exchange rate and market rate hikes in developing ones. The current international financial environment is highly prone to such developments, statistics or remarks.
You can’t escape your fate
In short, under the current circumstances in the international financial markets, the CB has limited ability to prevent exchange rate hikes. All central bankers are aware that the pressure cannot be averted simply by selling FX. Raising interest rate might prevent an excessive increase in the exchange rate. But at the end of the day, you cannot escape your fate.
Moreover, the latest interest rate raises of the Bank, especially the last one, makes you think “would it be better if it did not raise the rate at all?” Here is what I mean, though it is a bit “technical”: the CB sells liquidity to banks at different interest rates. The weighted average of these is called the “average cost of funding.” In its Tuesday meeting, the MPC increased only one of these rates and did this in a way that not many banks will “have to” borrow at that rate. This step might be interpreted as “timid” by the market. So, from this perspective I am thinking whether it would be better if the CB did not raise any rate at all.
This commentary was published in Radikal daily on 22.08.2013