Why Turkey Had to Simplify Its Tangled Interest Rates: QuickTake

(Bloomberg) -- Turkey’s central bank has simplified a multi-rate structure that for years left investors struggling to understand its policy. By more than doubling the one-week repo rate, and establishing it as the new benchmark, the bank hopes to end years of confusion about which measure to watch in its tug-of-war with President Recep Tayyip Erdogan. After the adjustment, the benchmark rate will be 16.5 percent, unchanged from the current main funding rate. Happier investors may help Turkey arrest a slide in its currency.

1. How does the new structure work?

According to the central bank, all funding will be done through the one-week repo rate, while the overnight lending and borrowing rates will be placed equidistant at 150 basis points above and below the benchmark, respectively.

2. What drove the change?

Since assuming the top job at the bank, Governor Murat Cetinkaya has said that abandoning the multi-rate framework was a priority. The bank’s main objective was to minimize the uncertainty caused by the multiple rates, which allowed the bank to adjust the cost of funding it provided to commercial lenders every day if it so wanted. While the multi-rate structure gave the bank flexibility when fighting bouts of currency weakness, the simpler framework makes bank policy more credible, Cetinkaya has said. Investors had been pressing for Turkey’s monetary policy to be more predictable and easier to understand.

3. Why did Turkey have such a complicated framework?

The multi-rate setup was the brainchild of Cetinkaya’s predecessor, Erdem Basci, who stepped down in 2016. He said the wider interest-rate corridor allowed him to cope with global uncertainties following the 2008 financial crisis. Critics said it served as a vehicle to pursue excessively loose policy at times.

4. Why change now?

The lira has been under huge pressure over the past few weeks amid concerns that Turkey’s economy is overheating and the central bank is unwilling to act against political pressure to keep rates low. (Erdogan, who has made himself Turkey’s most powerful leader since its founding, supports lower rates and takes issue with the common wisdom that they cause inflation.) Monetary policy makers held an emergency meeting and raised rates on May 23, after the lira’s 2018 decline exceeded 20 percent. The bank seems to have considered this to be a good time to finalize simplification and provide more support for the currency in an effort to backstop the emergency hike.

5. How does the new system work?

The bank will begin providing funding through the repo rate on June 1, but because of the maturity mismatch between the new benchmark and the currently used late liquidity window, the latter will be gradually phased out over the course of a week. That operational transition period will come to an end on June 7, after which the late liquidity window rate will be set at 19.5 percent, compared to the current level of 16.5 percent. That rate was originally designed as an emergency funding source for banks that had mismanaged their daily liquidity needs, but had turned into the only source for the past year and a half. It should return to its original function as an emergency rate. The overnight lending and borrowing rates will be set at 18 percent and 15 percent, from 9.25 percent and 7.25 percent currently.

6. Will it work?

Judging from the initial reaction in the currency, which jumped the most in a decade on a closing basis, investors seem to like the clarity this brings to the policy outlook. The moves also show policy makers are being proactive in their fight against the slide in the currency, after weeks of investor complaints that their actions have been too little, too late.

The Reference Shelf

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