'The BRSA must step in. Otherwise might appear the risk that the steps by the CB not only proves ineffective but also works in the adverse direction.'

I am getting quite board of writing on the Central Bank of Turkey's (CBT) policies. I have already announced that I have submitted the textbook I have been working on for long to the publisher. Since the book is on monetary economics, I referred to the CBT several times throughout the book. For instance to form the index of the book, I searched for the abbreviation with boredom. It was the deadline and I had to send the book to the publishers immediately. And the search program I was using stopped responding quite frequently. I was quite bored of seeing the abbreviation everywhere. What is more, the new monetary policy framework was announced and this column also got its share of the CBT. But despite being bored, I still have to write about the CBT which is on top of the economic agenda.

Important problems
Previously on the CBT: To begin with, there are important problems to be tackled: First, there is extensively low interest rates and abundant liquidity in developed countries. Second and in association with the first one, capital inflows in Turkey in the recent period increasingly are short term funds. Third, rapid credit expansion across banks is observed. Fourth, these two phenomena are interrelated. Fifth, under such circumstances, there appears an upwards pressure on the value of the lira. Sixth, it is expected that the appreciation in lira will continue as long as the first factor is in effect unless a measure is taken. This intensifies the first problem further.

The short-cut solution to the listed problems is to copy the measures taken by some market economy countries: to limit short term capital inflows. Israel has recently joined this group. But Turkey did not choose this path. The political authority has declared several times that it is against measures that restrict capital movements.

Under these circumstances the solution to the mentioned problems becomes complicated. The path the CBT takes goes as follow: First, it wants to reduce the amount of funds the banks can extent in form of credits (this is why the required reserve ratio was increased). Second, it seeks to discourage short term capital inflows by reducing the policy rate. Some market economies' attempt to increase interest rates works for the purpose of the CBT in this sense. Third, it tries to cause volatility by widening the difference between borrowing and lending interest rate.

The BRSA must step in
This policy, which is routine-breaking and bold, faces some important challenges. First, the banking system suffers from liquidity shortage. Therefore, to ensure that short term market rate is close to the policy rate, the Bank has to inject back to the market the liquidity withdrawn by increasing the required reserve ratio. This is clearly contradictory. This contradiction would apply even if the interest rate was not lowered; but it has become even sharper now.

The second problem has been acknowledged by monetary economist years ago: Even if you increase the required reserve ratio to reduce the amount of credits extended  by banks, they can come up with new sources of funds. For instance, last year the banking system expanded credit volume through the rise in foreign funds rather than the increase in deposits. If you cannot block the former channel, the effectiveness of the measures you implement would be reduced.

These critical challenges facing the CBT's new policy framework can be eased if the BRSA (Banking Regulation and Supervision Agency) steps in. Otherwise might appear the risk that the steps by the CB not only proves ineffective but also works in the opposite direction. The upwards pressure the hike in commodity prices might cause on inflation rate is another problem area, but I prefer not to consider this as a 'third' problem. I will deal with the BRSA's intervention and the concerns about inflation on Tuesday.

This commentary was published in Radikal daily on 29.01.2011