IT IS TIME to offer a few guesstimates on what 2021 may bring. My focus is on the Turkish economy and finances. First, a very quick reminder of what has happened over the last three years. I am concentrating on monetary policy only, not on structural weaknesses and such. I emphasize endogenous money, and don’t rely much on a general old-style Keynesian framework that may have led to the debacles of yesteryears.

ENDOGENOUS MONEY

Money is probably endogenous in Turkey. Endogenous money means that money is created not by fiat, but by the exigencies of the financial system. Once loans have been granted and deposits have increased so core liabilities match to a large degree core assets, central banks accommodate demand for central bank money so as to guarantee solvency and manage systemic liquidity. In Turkey, the system is bankbased, and banks have also rather substantial non-core liabilities. Both core and non-core liabilities create assets. Money responds to asset creation; causality runs from assets (loans) to monetary aggregates. This is one view, and the evidence seems to shore up this conjecture. Hence, the Central Bank can only control the interest rates but not the supply of reserves. In other words, the Central Bank can either control interest rates or the quantity of its liabilities. In that case, barring the impact of cross-border capital flows on the currency and bond markets, the Central Bank can in principle use its interest rate as an exogenous policy tool, at least when inflows abound, but not its supply of money. There is also the view that the Central Bank may not fully accommodate reserves demanded by commercial banks. If there are liquidity constraints, banks could overcome such constraints imposed via liability management. The liquidity preference view is the third approach, which questions the demand-driven money supply approach. Because economic agents have different liquidity preferences about the amount of money they wish to hold, if the supply of deposits is insufficient to meet the demand for loans, individual preferences will change relative interest rates to fill the gap by increasing the supply of deposits and reducing the demand for loans. This hardly fits the Turkish case though, where deposits are almost always in short supply, and the game is not a stage game whereby banks compete for deposits at time t=1 and lend at time t=2 accordingly. Let’s bear this in mind.

WHAT HAPPENED IN 2017?

In late 2016 it became obvious that the economy would be stagnating unless incentives, credit expansion and suchlike come to the rescue. In other words, without state intervention in the form of direct support some segments of Turkish private businesses couldn’t do the job. This is almost always true, that is, true regardless of circumstances, but let’s forget this for a moment. Instead of further relying on public expenditures and transfers, the Credit Guarantee Fund was established. It basically delayed a quick deterioration of public finances. Backed by a continual portfolio investment flow accruing to EMs, Turkey attracted funds for a span of 28 weeks consecutively, and businesses went on. The USD/TRY exchange rate remained around 3.55 for the best part of the year. Then, beginning in September the lira depreciated bit by bit. The relative topology of banking and credit was ‘translated’ in the metric space; risk aversion and all that got out of hand. Yet the credit mapping didn’t change, and risk management came back in H2 2017. It was a strange year but at least public finances had just begun to deteriorate, the exchange rate wasn’t spiraling out yet, and the Central Bank had positive net reserves. There was room for further moves. This was my main message as regards the credit Guarantee Fund. I looked at it as a delaying device. Let’s not forget that the broad money supply (M2) growth rate wasn’t that high at that point.

THE 2018 DEBACLE

Delaying what, the inevitable? Well, we didn’t know at that time. It all started in late April 2018. Because lira depreciation that had begun in September 2017 did only little damage: 3.77 USD/TRY by the end of 2017 wasn’t in fact that high if we judge by today’s standards. The February global stock exchange and bond volatility surges didn’t do much harm either. By the end of April 2018 the lira stood at 4 against the dollar. Then, the London visit changed everything and by May 23, the 4.85 level was tested. Then it eased until such time as the Brunson crisis erupted, which carried the exchange rate into the ‘overshooting’ zone. The rate of interest had to be increased quickly, and the lira stabilized again. However, the CBRT funding rate had gone up to 24% by September 19, 2018, and by April 1, 2019 it stood at 25.5%. That was only a rehearsal of what was to come but we didn’t know that yet. Obviously, the stop-go cycles did incredible damage to the working of the real sector. The only good thing that resulted was the reduction in corporate short position: because businessmen couldn’t and wouldn’t invest they became net payers of debt to the outside world. Then all of a sudden the back-up font that was always latent was enforced with unseen vigor.

THE 2019 SEA-CHANGE AND THE 2020 U-TURN

That the TRY rate was repressed starting from July 2019 until July 2020 is obvious. At the back of the scene not only the rate of interest was cut time and again, but also money supply increased. And not only that because all selective incentives were also applied. True, for the good part of the last decade money was endogenous and credit was demand-driven, but this time all limits were stressed to Granger-cause demand of some sort ahead of schedule. The only response to the outbreak was to shore up domestic demand with the hope that the virus would be gone come summer. Hard won FX reserves quickly eroded. In a curious twist, an aggressively expansionary policy was enforced on all fronts, only at the gain of temporary economic revival and at the expense of huge FX reserves. Then, as expected from some time on, all of a sudden there was a U-turn. Now orthodox monetary policy is on, and we were anticipating 150 basis points policy rate increase as I penned this article. Because inflation is high, and its momentum is also strong, a 16.5% weekly repo rate looks necessary. It can also be deemed sufficient, but we have to wait and see.

CREDIT AND ASSET SUBSTITUTION

Now a Central Bank study conjectures that money is indeed endogenous, i.e. the CBRT is accommodative of the demand for money. My own back-of-the-envelope basic econometric exercises indeed suggest the following mechanism: Demand for credit Granger-causes supply of credit; supply of credit causes the demand for broad money; non-core liabilities finance the 1/5 addendum to loan (asset) demand and creation; the CBRT regulates the exchange rate and bond yields. Even development banks are behaving pro-cyclically. The upshot is, despite many claims to the contrary except short spans of turmoil demand is the main determinant, credit being almost surely not in short supply, and Central Bank money being almost always accommodative. Currently it is more than that. The clearer implications of this claim are twofold: (a) as the money base – and M2 and M3 – are almost always accommodative, currency (asset) substitution doesn’t easily pick up because money supply rises in tandem with both deposit and non-core liability increases as loans go up, so the ratio of residents FX deposits to the money supply gets automatically stabilized at least to a certain extent; (b) without the cross-border flows, FX-denominated corporate and bank debt, and the current account deficit, the TRY interest rate could effectively be used as a policy tool. The extent of such use depends on the need of the FX-debt to be rolled over, and on the trend currency (asset) substitution phenomenon. Managing the second part is only to some extent within the power of the Central Bank, and certainly not so if net reserves are negative and credibility is low. Now it is high time for credibility build-up anew.

2021: MAIN SCENARIO

I think interest rate policy will be the main tool. Hence: (a) rates will remain high for at least two quarters; (b) if money is endogenous and demand Granger-cause credit supply, money supply growth will be much lower, and credit supply would shrink by a wide margin; (c) because there is accumulated NPL in the system, banks would manage risks accordingly and try to keep a high net interest margin (NIM). Accordingly, reversing dollarization isn’t the agenda of the day; it would take over 20% net TRY interest and at least 5% ex post real rate, a rate banks are unable to offer.

But if money supply is kept in check, and if TRY rates are sufficiently high, then portfolio inflows may begin to pour in, and due to the rediscount mechanism, negative net reserves would slowly turn to positive during the year. This is what the CBRT seems to think. Low growth, little current account deficit, little credit expansion, and in exchange you get an exchange rate that is under control: this is the plan for Q1 and probably for Q2. The plan may work in the short-run, unless the outbreak imposes itself in Q1 2021 as a fully-fledged economic shock variable to a degree unseen in 2020.