How did Turkey’s Central Bank get creative?
Turkey’s Central Bank has no reserves, but it can continue to intervene in currency markets (#2)
This is an exciting story that gets more bizarre during the Covid-19 pandemic and will probably occupy the headlines once again later this year. The latest episodes of this creativity will be the topic of another entry (or multiple entries). For now, let’s pay attention to the starting point and first years of the ‘no reserves’ era.
Concerns and crisis management
It all started with the attempts to mitigate the effects of the currency crisis around four years ago and got complicated in the ensuing years.
The latest recession in the Turkish economy was in 2018. The mounting economic problems entailed eroding central bank (the CB) reserves. In late 2018, the non-performing loans problem widespread in the construction and energy sector was among the significant concerns of the Erdogan administration, which forced domestic banks and the state authorities to search for new rounds of non-financial corporations’ debt restructurings.
Amid the changing global financial cycle in 2019, the renewal of capital inflows in the first two months provided relief for state managers, who were busy promoting a quick recovery despite the poor economic expectations of observers. The cancellation of Istanbul’s mayoral election and weeks of political uncertainty after the local elections of March 31, 2019, encouraged portfolio outflows and greater currency volatility. The CB intervened once again and tried to stabilize the currency.
Squeezing the international swap market back in August 2018, the banking authority (Banking Regulation and Supervision Agency) previously attempted to make it harder for market players to short sell Lira in international markets. In that vein, it was not only the central bank that the state managers were actively using to postpone further depreciation of the Lira.
But back to the CB, which initially struggled in 2018-19. The CB used money swaps to meet the short-term liquidity needs of domestic banks in small but visible amounts after the 2016 coup attempt. Give lira and borrow USD short-term, for a couple of weeks, maybe months. Everyday transactions for a central bank. In spring 2019, however, the volume of swaps increased tremendously. It was not something ordinary anymore. Right after the Financial Times commented on the situation, pointing out the loss of reserves (though known and pointed out by other commentators before), it became evident that the bank borrowed off-balance-sheet while showing the borrowed money as reserves.
The graph below shows the turning point: March 2019 (the reason was the capital outflows during the political turbulence, and the first sign of a jump is August 2018, the month of one of the severest currency crises in recent years).
CB’s Outstanding Swap Liabilities (2018-19, million USD)
Perpetual motion machine
The CB’s net foreign exchange reserves declined rapidly in spring 2019 to under 30 billion USD, and then the decline almost stopped. Despite the loss of billions of dollars worth of foreign exchange reserves in 2019 and 2020, the CB’s net assets did not change on paper because it started to record the borrowed USD as net assets. The other side of the transactions was domestic banks, followed by mainly Qatar Central Bank and, to a lesser extent, the People’s Bank of China. The limits of swap operations with Qatar reached 6 billion USD in 2019. Ongoing swaps with domestic banks (not limited to public banks) had a volume of around 14 billion USD as of early 2020 when the total volume was revolving below 20 billion USD.
Excluding the off-balance sheet liabilities, the Bank’s intervention capacity had clearly eroded considerably. To compensate for the narrowed power, the CB had to rely on public banks, which became increasingly active in the foreign exchange market around the same time. It is impossible to precisely know the volume of USD sold in the market to defend the Lira; however, it is safe to claim that Turkish public banks intervened several times during the 2018-19 crisis with transactions worth billions of USD.
Because of its size and significance, it is best to label this a relatively new circulation mechanism that implies that CB borrows short-term from banks and finds a way to record them as net reserves. It reminds a perpetual motion machine, a fictitious circulation mechanism that can only be maintained if demand for the USD is kept low.
There have been two side effects of this creativity. As they mature, these swap liabilities become the dollars owed by the CB. In the CB’s defence, the other legs of these money swaps are the CB assets. However, since they are denominated in lira, it is controversial to add these into international reserves as if they are denominated in USD. The domestic and international financial community knew about the controversy. It strengthened the expectation for currency volatility, sending alert signals that the CB wanted to avoid.
The related second side effect was the asset dollarization in Turkey, reaching the highest levels in the country’s history. It started even before the August 2018 currency collapse but reached unprecedented levels in 2020. The dollar rush played a massive role in the CB orientation and responses during the Covid-19 pandemic.
The questions such as did Turkey shift to a managed floating regime or why an emergency measure such as a foreign exchange-protected lira scheme was introduced in late 2021 can only be answered after remembering the movie-like scenes in the CB press conferences and the heavily mocked declarations of the then Finance and Treasury Minister in 2019 and 2020.
This is the short version of how Turkish CB got creative. I am planning to write on the second episode (2021-22) of ‘how I stopped worrying and loved to act like I had reserves’ next week.