As the market swings: The sector’s response to a rapidly shifting monetary policy

The downside to the growth in retail lending in Turkey in 2010 and 2011 was a rapid increase in the current account deficit as consumers took advantage of greater access to credit to purchase imported products that were previously out of reach financially. At the same time, the lira, buoyed by strong capital inflows, strengthened, making imports less expensive and raising the cost of Turkish exports. The government thus faced a dilemma that was not uncommon for emerging markets during 2010 and 2011: how to slow the economy without raising interest rates, which would exacerbate hot money inflows and further appreciate the lira.

AN UNORTHODOX POLICY: From October 2010 to April 2011, the Central Bank of the Republic of Turkey (CBRT) had a so-called two-pronged approach: raising reserve requirements while at the same time lowering the policy rate, known in Turkey since May 2010 as the one-week repo rate. The process of increasing reserve requirements began in a fairly mild manner, increasing lira and foreign exchange reserve requirements from 5% to 5.5% in October 2010. However, the scheme quickly escalated over the following months; by the end of April 2011, the reserve requirement for lira deposits of maturity of up to one month had hit 16%.

At the same time, the policy rate was also lowered in late 2010 and early 2011. In attempt to slow hot money inflows the rate was lowered from 7% to 6.5% in December 2010, and then further to 6.25% in January 2011. Finally, in an effort to deter currency speculation and curb excess volatility in the value of the lira, the CBRT widened the interest rate corridor, defined as the difference between its overnight lending and borrowing rates. A dramatic changes occurred in November 2010 when the overnight borrowing rate was reduced by 400 basis points from 5.75% to 1.75%. The central bank’s general approach during this period (late-2010 to August 2011) was one of so-called downside interest rate volatility.

INITIAL EFFECTS: Raising reserve requirements can in theory slow lending, although it is considered to be an indirect channel. In late 2010 and the first half of 2011 the, CBRT continued to provide liquidity to the market through its open market operations. At the same time, the banks enjoyed comfortable loan-to-deposit ratios and no rush for deposits, reducing their willingness to raise rates on their loans. Given the high competition in the Turkish banking sector, in the early months of 2011, it appears that lenders hesitated to be the first to raise rates and instead took a hit on their margins.

Indeed, loan pricing in the sector remained fairly constant during this period, initially even falling. According to data from the CBRT, the weighted average interest rate for lira cash loans stood at 12.3% on October 15, 2010, falling to 11.95% by March 4, 2011. Similarly, over this same period, the price of vehicle loan declined from 10.7% to 10.4%. Prices drifted up a bit between March and June, with cash loans priced at 12.9% as of June 3, 2011, while vehicle loans hit 11.1%.

The effect on the volume of lending was limited as well, with the value of outstanding consumer loans continuing to grow, rising from about TL118bn (€50.2bn) in October 2010 to TL154.5bn (€65.7bn) in June 2011, according to data from the Banking Regulation and Supervision Agency (BDDK).

AN ALTERNATIVE: Finding it difficult to slow lending through these channels, the government turned to the BDDK, altering the regulations that affect the ability of banks to lend. In June 2011, the sector’s regulator announced two changes on the same day. First, it increased general provisioning for consumer loans (general and credit card) from 1% to 4% for banks whose consumer loan portfolio exceeded 20% of their total loan book. It was hoped that this change would discourage banks from extending this type of credit, as more provisions mean lower profitability results.

However, the second change was likely more effective in curbing lending. For this same set of consumer loans, the BDDK increased the risk weights that are used in calculating capital adequacy ratios (CARs). For loans of maturity of up to two years, the weight increased from 100% to 150%. For longer loans, it was raised from 100% to 200%. Increasing these weights required banks to set aside more funds, therefore reducing the amount of money they had available to lend.

Unlike the adjustments to the reserve requirements, this policy change had a nearly immediate impact, as banks translated increased capitalisation requirements to higher loan rates. The average price for a cash loan jumped from 12.93% on June 3, 2011 to 15.63% on July 1, according to data from the CBRT. Data from the BDDK show that the rate of growth of personal finance loans also slowed. Between January 2010 and June 2011, this category of lending increased at a compound monthly growth rate of 2.6%, while between July 2011 and December 2011, this figure fell to less than 1%.

NOT OVER YET: The CBRT shifted gears in August 2011, lowering the policy rate to 5.75% due to concern a renewed global economic slowdown. The central bank also narrowed the interest rate corridor, raising the overnight borrowing rate by 350 basis points to 5% to reduce currency volatility and boost the lira. As the lira continued to slide in the markets, the CBRT took a more dramatic step, and in October it raised the overnight lending rate from 9% to 12.5%, significantly above the prevailing policy rate of 5.75%. Again, the point was to increase uncertainty to deter currency speculation and support appreciation of the lira, which had fallen substantially over the course of 2011.

At the time that the new overnight lending rate was announced, the CBRT’s governor Erdem Başçı told the press that the central bank would alternate between making funding available through one-week repos and overnight lending, as deemed necessary given market conditions. From late October until late December 2011, the weighted average cost of funding from the CBRT hovered around 7%, according to an analysis by İş Investment. However, without having any clarity as to where rates might be on a day-to-day basis, banks raised their pricing following the October announcement, with the weighted average interest rate for lira loans jumping almost immediately for cash, vehicle, housing and commercial loans. For example, between October 21 and November 4, the price of a commercial loan increased from 11.88% to 14.66%.

On December 27, 2011, the CBRT announced a new policy, again creating confusion in the markets, this time stating that, going forward, the central bank would define each day as “normal” or “extraordinary”. On the extraordinary days, the bank would suspend selling one-week repos. Strangely, these such days turned out to be the norm, and by January 6, 2012, the average cost of funding had reached 11.88%. Much to the relief of the banks, the CBRT subsequently eased monetary conditions mid-month, resuming funding at 5.75% on January 10, which caused the weighted cost of funding to fall again to about 7.5%. The country’s lenders shifted their rates in response, with cash loan rates declining from 20.1% on January 6 to 19.3% on February 24. This same trend was observed in commercial and housing credit. However, loan pricing still sits far above the lows that were seen in the first half of 2011.