In the aftermath of the global economic crisis, the Turkish economy experienced a very strong recovery. The growth rate reached more than 9 percent in 2010 fueled by an astonishing loan expansion that reached a 40 percent year-on-year increase. This expansion provoked a very high domestic demand, which in turn produced a huge current account deficit (CAD), while the Turkish lira was appreciating dangerously under the pressure of the flow of hot money. Admittedly, the Turkish economy truck was going at full speed towards the wall and something had to be done.
At this difficult time, the central bank emerged as the unique savior, since the government was very happy with the growth performance. It was the central bank that took on the responsibility of tackling the worsening imbalances. The problem was that one of the rules of thumb in economics is that for each specific goal you must use one specific tool. Certainly, as the central bank, besides its unique mission of securing price stability, it wanted to cool the soaring loan expansion and to address the increasing CAD, preventing the hot money flows. It had to use an innovative tool like the “daily interest rate corridor” and a rather old one, the reserve requirements.
The adoption of this new monetary policy framework immediately raised a hot debate among both local and foreign economists. Some of them criticized the new policy, asserting that it was confusing and inefficient. Others supported it, like Joseph Stiglitz, who suggested that the Turkish Central Bank be nominated for the Nobel Prize. The public at large has not been interested in this debate, not surprisingly. Now, the public should be aware that the performance of the Turkish economy in the near future will depend on the lessons the central bank and the government took from this experience.
Refet Gürkaynak, a bright Turkish economist from Bilkent University, who also worked as a research fellow at the US Federal Reserve (the Fed), discussed this “moving period” at the Bahçeşehir University Center for Economic and Social Research (BETAM) seminars last Thursday. Gürkaynak says first of all, that the central bank was obliged to move because the government was fueling the economy by increasing public expenditures. In 2011, the government pursued its expansionary fiscal policy albeit the budget deficit was decreasing due to a rapid increase in customs revenues. That reduced budget deficit opportunity was indeed a direct consequence of increased imports widening the CAD and not the result of a tight fiscal policy.
So, the central bank increased the reserve requirements in order to cool the credit expansion and created a new tool, namely the “interest rate corridor,” to produce a discrete uncertainty about money market interest rates in order to discourage speculative capital flows (the famous carry trade). The reserve requirement tool did not work since it put pressure on the deposits rather than on the credits; banks found other financial resources. The Banking Regulation and Supervision Agency (BDDK) has been obliged to intervene, albeit late, increasing the reserve requirements for credits. Credit expansion eased and the yearly increase declined up to 15 percent. Gürkaynak suggests that this prerogative has to be given to the central bank, rather than the BDDK. I agree.
The implementation of the interest rate corridor also helped. The flow of hot money almost stopped and the Turkish lira depreciated by approximately 20 percent. The new monetary policy produced the expected results to some extent: the CAD decreased from 10 percent to less than 7 percent but growth was down to 3 percent, much lower than expected, and inflation went beyond its target of 5 percent. Gürkaynak thinks that this adverse side effect is dangerous for the credibility of the central bank. Indeed, their credibility is crucial for the success of the inflation targeting plan. He also points out the adverse effect on investments coming from the uncertainty regarding interest rates, since this uncertainty is valid not only for hot money but also for other investors.
I agree with Gürkaynak that the new monetary framework has been a second best policy. In other words, it has been a necessity but not an optimal policy. For the future we need better coordination between monetary and fiscal policy, including structural reforms. The ball is in the government's court.
Note: These issues will be discussed by a panel organized by BETAM tomorrow, Wednesday, at 2.30 pm at Bahçeşehir University featuring the participation of Central Bank Chief Economist Hakan Kara, Asaf S. Akat from Bilkent Universty, Cevedt Akçay, chief economist of Yapı Kredi Bank and Murat Üçer from Global Source Partners.