For a while, I have been touching upon an issue that is big of a problem for the implementation of monetary policy. The fundamental question was: Should monetary policy be used to prevent the asset price bubbles that played a major role in the emergence of the crisis? The commentary on this issue was published on last Thursday. At the end of that commentary I asked questions one after another: So, what can central banks do in the event of a credit expansion? A problem arises just at the beginning: At what pace credit expansion is rapid? What if a credit expansion we consider rapid in fact does pose any risk for the financial system? Assume that you overcome this challenge and decided that the things are not on track in the credit market? Then what would you do?

These are questions that occupied the Central Bank's mind in 2004. Back then, the Central Bank was concerned about to possible developments: First, rapid credit expansion, stimulating directly imports and intermediate goods imports for domestically produced final goods, leads to a rise in current account deficit. Current account deficit is high also due to other reasons; this is a major issue of discussion and creates a significant risk. The discussions also affect the credibility of monetary policy. Second, cost of domestic credits is higher than foreign credits thanks to ample liquidity. This encourages the corporate sector to borrow more and more from abroad. While the debt of public sector decreases, that of corporate sector increases. Banks' payables and receivables in dollar terms are balanced. However, corporate sector's payables in dollar terms rise gradually above receivables in dollar terms. In the event of a possible exchange rate rise, balance of payments of the corporate sector can be disturbed resulting in lower production and employment. More precisely, this is a considerable risk. However, if such risk is realized, banking sector, which is newly collecting itself, can be affected adversely. This in turn deteriorates further the situation of the corporate sector. In short, it is a vicious circle.

So, what can you do? If you focus on the second risk, the simple answer will be lowering the interest rates. However, monetary authority argues that this option has two drawbacks. First, interest rate lower than necessary has the potential to elevate the risk further given that the economy is already growing above the potential. Thus, a significant fall in interest rates can heat the economy and increase import demand further. Second, Turkey had lived with high inflation since the mid-1970s and for the first time over a long period has the change to overcome this problem. In that period, inflation had recently fallen back to single-digit levels. So, fight against inflation must not be stopped.

This framework answers the questions asked at the beginning. To decide what level of credit expansion is dangerous, it is not enough to examine only the credit figures; the economy must be examined as a whole. Where do imbalances arise? What is the relation between these unbalances and credit expansion? In the above framework, this relationship increases in foreign borrowing of corporate sector and in imports are set as the imbalances related with credit expansion. It is decided that interest rate policy cannot be used to reduce risks arising accordingly.

In that case, an alternative policy option is: First, measures to limit even slightly the rate of increase in the volume of domestic credits extended by banks. For instance, increasing the capital requirement might be a measure to this end. Second is making things slightly harder for firms foreign debts of which rise gradually. I remember that back then I talked with the President of Chilean Central Bank in Washington to hear his experiences in particular of the second option.

Of course everyone does not have to agree with the framework I draw above. Some can say that a monetary policy that takes into account the real value of the exchange rate must be implemented. Or some can argue that credit expansion is desirable for banks which are newly dressing the wounds of the crisis and are in the middle of the process of normalizing their activities. Nonetheless, the questions asked at the beginning and the framework drafted above is one of the most important issues the monetary authorities will have to think through. This is mainly why the IMF elaborated on this issue on the third chapter of the World Economic Outlook report published right before the Istanbul meetings.

This commentary was published in Radikal daily on 26.10.2009