Hakan Kara, the chief economist of the Central Bank of the Republic of Turkey delivered a lecture at a course of the MNB Department (Theoretical and practical challenges in monetary policy). After the lecture Mr. Kara gave an interview to Kristóf Lehmann (Head of the MNB Department) about the monetary policy lessons of the crisis for emerging economies, international monetary policy spill-overs, the effects on the Turkish economy and how the Central Bank of the Republic of Turkey responded to the challenges.
Kristóf Lehmann (KL): What are the most important lessons of the global financial crises for a small open emerging economy central bank?
Hakan Kara (HK): There are several lessons. First, the global crisis and the post-crisis dynamics have shown that conventional inflation targeting is not adequate to cope with external finance and global liquidity shocks. The dominating role of US dollar as a funding and invoicing currency complicates the role of exchange rate in a small open economy. Contrary to the textbook wisdom, exchange rate movements driven by financial shocks may act as an amplifier rather than a shock absorber. Second, the global crisis have highlighted the need to have a macro view on financial stability. Small open economy policy makers have noticed that the interaction between leverage, external finance, and balance sheet mismatches may have far important implications than they thought. Building buffers in good times and using them in bad times turned out to be a simple but very powerful strategy. Third, the significant policy trade-offs brought by post-crisis dynamics have highlighted the need for more deeply involvement of central banks in building tools to cope with macro-financial shocks. Finally, central bankers realized that we need to have a better understanding of macro-financial linkages, longer term balance-sheet effects, role of flow vs. stock variables in our models, which had tremendous implications for the profile of human capital and technical expertise at central banks. All these lessons have transformed the central banking paradigm, necessitating small open economy central banks to be more open-minded and innovative regarding the design of country-specific policy frameworks.
KL: Did the US (Fed) monetary policy significantly affect your economy? What was the main challenge for the Turkish Central Bank?
HK: US monetary policy affects our economy mainly through external finance channel, similar to many other emerging economies. Having a structural current account deficit with partial financial dollarization, our financial markets are relatively sensitive to global liquidity conditions, and hence, to Fed’s policy. For example, since the global crisis there is a very tight correlation between Turkish banks’ external liabilities and Fed’s balance sheet expansion. Exchange rate and capital flow volatility have increased significantly during the post-crisis period, driven by large fluctuations in global factors. The volatility in capital flows have weakened the control over domestic financial conditions. The interaction between capital flows, exchange rate, and credit flows have amplified the business cycles, leading to significant volatility in the economic activity and inflation. Moreover, long periods of excessive global liquidity expansion have led to an accumulation of macro-financial risks such as rapid credit growth, over-borrowing and a widening current account deficit. For example, by the end of 2010, Turkey had 35 percent consumer loan growth and 20 percent real appreciation in one year. At that time, we were worried about the risk of a sudden stop should the Fed decide to taper-off its balance sheet.
KL: What was your general strategy to deal with the trade-offs caused by these spill-overs?
HK: Our main strategy was to adopt a new policy framework to contain macro-financial risks and to address the challenges posed by volatile capital flows. To this end, the conventional inflation targeting regime was modified by incorporating financial stability as a supplementary objective. Price stability remained as the overriding objective, while policy focus was broadened to include macro-financial risks—especially macroeconomic volatility caused by excessive global liquidity cycles. The new strategy focused on containing the adverse effects of the capital flow volatility on the domestic economy. Faced by rapidly widening current account deficits and a deterioration in the quality of external finance in 2010, priority was given to reducing the probability of a sudden disruption in external financial flows. In this context, we focused on containing excessive borrowing and reducing exchange rate misalignments. We have also devised new instruments to smooth the business cycles fluctuations by dampening the interaction between capital flows, exchange rates and credit growth. To this end, we have expanded the policy toolkit to include brand new tools such as “reserve option mechanism” and a “flexible interest rate corridor” system. The former intended to reduce the sensitivity of credit to external flows, while the latter aimed to smooth the short capital flows by using interest rate volatility as an additional tool.
KL: What about policy coordination? Was the central bank acted alone during this process or did you have support to deal with spillovers from other relevant institutions?
HK: Initially central bank went solo, by using purely monetary tools for macroprudential goals. These instruments were useful in dealing with the trade-offs but the central bank lacked the direct tools to respond to systemic risks stemming from rapid credit growth, because the banking regulation and supervision was conducted by a separate institution. More coordination was needed to address the systemic aspects of financial stability with more targeted tools. The foundation of a Financial Stability Committee in 2011 was a significant step towards establishing a formal macroprudential framework in Turkey. The coordination provided by this committee helped the relevant institutions to internalize the macroeconomic and systemic dimension of financial stability, lifting some of the weight off the central bank’s shoulders. Through the recommendations of this committee, relevant institutions have taken a comprehensive set of measures to contain excessive leverage and improve the quality of external financing. The measures included higher risk weights and general provisions for consumer loans, higher minimum payments for credit card debt, and loan-to-value caps for housing and vehicle loans, and maturity restrictions for uncollateralized consumer loans. Moreover, we have also differentiated reserve requirements across liability structures to lengthen the maturity of banks’ external borrowing.
KL: The framework you adopted to integrate financial stability into inflation targeting since 2011 sounds quite complex and innovative. Are you satisfied with the results?
HK: I think they have served fairly well during extraordinary conditions. Adoption of the new policy framework have significantly contributed to the external and internal rebalancing process and bolstered the resilience of the economy against global shocks. Since 2011, the current account deficit has been on a steady declining trend and the sensitivity of economic activity to capital flow volatility have weakened considerably. Empirical evidence shows that domestic credit growth and exchange rates have become less sensitive to capital flows. As a consequence, domestic economic activity become less sensitive to cross-border flows.
However, I should admit that the complexity of the framework has also brought some costs. The new multiple-tools-multiple-objectives strategy complicated the communication of monetary policy. Uncertainty regarding the transmission mechanism of new instruments hampered the predictability and accountability of policies. The theoretical and empirical literature on the effectiveness of these instruments were scarce and not robust enough to convince the public. Given the inherently vague nature of financial stability and the difficulty of linking each tool to objectives, the joint use of multiple instruments for multiple purposes posed significant communication challenges for the central bank.
Overall, our experience have demonstrated that targeted macroprudential policies along with unconventional monetary measures can improve the tradeoffs posed by volatile capital flows. However, it is also important to note that macroprudential policies cannot be a substitute for sound structural reforms. In many cases, macroprudential policies to contain the adverse effects from external spillovers can rather be regarded as second-best solutions that save time until deeper structural adjustments take place. To the extent structural policies are able to sufficiently increase the resilience of the economy on their own, there could be less of a role for unconventional monetary policy as well as for macroprudential policies. Therefore, in the long term, it is essential to undertake structural measures to improve the policy trade-offs. Recently, we have been working on the root causes of these structural issues. To this end, we have initiated a comprehensive project to address the risks associated with the unhedged FX denominated loans of the non-financial corporates.
KL: In 2016 some difficulties emerged for the Turkish economy. Did these change the monetary policy of the TCMB?
HK: The policies we have adopted between 2011 and 2015 were designed as a response to unconventional policies and massive balance sheet expansions across major central banks. Hence it should not be interpreted as a permanent shift towards unorthodoxy. Definitely, some of these innovative tools will stay in our toolkit for rainy days, but policy strategy should adopt to changing conditions. Geopolitical tensions, global shocks, and the domestic events have created challenges at different dimensions than we faced during the global crisis period. Having contained macro-financial risks and preserved a sound fiscal position in the past years, Turkey had enough buffers to deal with these new challenges. The government focused on delivering a concerted stimulus to prevent a downturn in economic activity, while the central bank have concentrated on the price stability objective to avoid a de-anchoring of inflation expectations. Meanwhile, gradually rising global inflation has signaled a normalization of leading central banks policies and a retrenchment of global liquidity. All these developments called for a recalibration of the policy approach. Accordingly we have designed a two pillar strategy. The first pillar adopts a simpler and more predictable monetary policy framework with a strengthened focus on price stability. The second pillar promotes active engagement of all relevant partners to ease the policy trade-offs associated with the disinflation process. To this end, we have announced a comprehensive plan to enhance policy coordination and support structural reforms to deliver lasting price stability.
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