The share of FX liabilities in the Central Bank’s total debt rose from 44 to 67 percent.

On Tuesday, I addressed the positive aspects of the Central Bank’s (CB) new policy that allowed banks to keep a certain proportion of reserve requirements on lira deposits in FX. Today let me talk about the downsides of the policy.

When selling securities to finance their budget deficit, the crisis countries of Europe pay extremely high interest rates as risk perception against their economies is high. This deteriorates their budget balances, further pushing up the interest that creditors ask for. Evidently, the fundamental solution to this critical problem is eliminating the risk perception against the crisis countries of Europe. This however is a hard task that requires time and that cannot be accomplished overnight. While doing their utmost to lower the risk appetite, the troubled countries of Europe should not be confined to borrowing on high interest rates. They should have the chance to sell securities on low interest. Nevertheless, Italy and Spain are in large need of borrowing via selling securities and there is only one institution that can purchase those on low interest rate: the European Central Bank, because it has the authority to print money.

Borrowing FX

If faced with high liquidity requirement, there are three options financial institutions can follow: borrowing from other financial institutions, selling assets, and borrowing from the central bank of the country. In times of severe financial crisis, institutions refrain from lending due to uncertainties, so the first option is out. The second one also fails as asset prices generally fall through the floor during crises. The only option left is asking the central bank for help. In such cases, central banks, via issuing money and helping out the troubled financial institutions can prevent a possible collapse. Just as the Federal Reserve did in 2008 in the US.

A central bank can print only the national currency. Therefore, if Turkish banks for instance, have a severe fund requirement to pay their FX liabilities and fail to meet the need via traditional options, the CB can lend only the FX in its reserves. This wouldn’t be a nice path to follow, however. In fact, regulations in effect stipulate an upper limit for banks’ FX borrowings except for transactions involving FX assets and thus it is a small probability that this option would be followed. Yet, the purpose of this commentary is different. Please think, why do banks prefer borrowing largely in FX? One key reason might be that the national economy is not sound. Inflation rate might be significantly high, for instance that agents prefer FX deposits over lira deposits. In such a country, treasury will be having difficulty in borrowing in domestic currency and thus will borrow FX. Again in such countries, the prices of goods and services will be considered in FX terms and even individual consumers will start carrying FX as cash.

In such a setting, it would be too naïve to think that balance sheets of central banks of such countries will get away unharmed. In such countries, total debt of central banks will predominantly be in FX terms rather than in national currency. Before the 2001 crisis in January, for example, 84 percent of the CB’s debt was in FX. With the establishment of economic stability, the ratio decreased gradually, to 50 percent by March 2006 and later fluctuated and settled at 44 percent. Recently, however, the ratio was on the hike; at 67 percent for the time being. Evidently, the underlying reason is not the instability of the pre-2001 era. Yet, there is a similarity, which relates to the very challenge ahead. I will continue.

This commentary was published in Radikal daily on 18.10.2012