Research paper

Fall, 2017
Why Research Option Mechanism adopted by Turkey after 2008
financial crisis could help to decrease the volatility of Turkish
lira?

Dr. Dora Piroska Sevinj Ahmadova

Abstract
Before financial crisis, Turkish central bank was indicated by its power of stabilizing economy
using price stability and low inflation tools. During 2008-2009 financial crisis, central banks
could observe that traditional money policies were not enough for stabilizing Turkish lira and
economy adequately. After deepening the crisis in the year of 2008, real economic situation had
collapsed and it made way think about applying unconventional ways of money policy. The
solution of Turkish central bank was to apply Reserve Option Mechanism (ROM) in order to
stabilize currency.

Introduction

After the global economic crisis, the priorities of developing countries and developed countries
have changed in order to be focused on monetary policy. In this process, developing countries
such as Turkey, were observing the impact of capital inflows and expansion of monetary policy
of developed countries. That was the reason why developing countries were trying to strengthen
their monetary policy with non-traditional policy tools.

Central Bank of the Republic of Turkey (CBRT) announced its “exit strategy” from traditional
policies since the mid of 2010, when crisis started. With this new strategies, Turkey aimed to
stabilise not only the price, but also financial stability and to decrease volatility of local currency.

In addition to the interest rate policy, which enables the interest rate corridor to be made
asymmetrical when necessary and to respond to the ever-changing economic and financial
conditions with active liquidity management, the reserve requirement policy has been
implemented as a complementary policy tool with the aim of financial stability.

The most important innovation has been the Reserve Option Mechanism (ROM), which has
brought a new and different dimension to the reserve requirement policy, while the required
reserves have been shifted to a multi-rate structure with rate differentiation on a maturity basis.

While it is a well-known rule and widespread practice for a central bank to make its reserves
from its own currency, the CBRT's ability to hold required reserves liabilities in gold and foreign
currency is noteworthy as the accumulation of international reserves that it has attracted.

This paper aims to investigate the reasons why ROM could stabilize the volatility of Turkish lira
after 2008 financial crisis. I argue that during 2010, there was a change in Required Reserves
Establishment which considered to keep up %10 of their liabilities in Euros or USD and precious
metals. It made way to increased liquidity of Turkish lira against foreign currencies during the
periods of inflow to country, and increased capacity of payable liabilities during the periods of
outflow. The system made possible to limit: the credit spread during FDI, the sensitivity of
lending to capital flows, volatility. As a result, it increases the stability of whole economic
system.

The methodology by which the analysis was conducted is literature review. Paper will start with
introduction, followed by quick overview of literature. Body part will include supportive facts
about argument and criticism. Conclusion part will observe results of the investigation and
further researches.

Literature review

ROM was introduced in 2011 and after that the first book that was dedicated to it was Alper, K. ,
Kara, H. Ve Yorukoglu, M. (2012) “Reserve Option Mechanism”. In their book, authors describe
the essence of ROM mechanism and the reasons that have driven the force to imply it. After that
CBRT started to publish annual reports of this mechanism with empirical results of the
development and stability of economy. In this reviews, it is apparent that thanks to this
mechanism, Turkey got rid of the crisis and currency volatility was reduced. The publications of
Oduncu, A., Akçelik, Y. ve Ermişoglu, E. on “Reserve Options Mechanism and FX Volatility”
written in 2013 give the reasons why this mechanism helped to pass crisis away.

Why ROM decreased the volatility of Turkish lira after 2008 crisis?
The law change in 2011 made it possible to keep some part of liabilities in foreign currencies and
precious metals. According to 2011 Required Reserves Communique, in all banks, up to %10 of
Turkish lira liabilities can be kept in US dollars or Euros. Additionally, in order to keep the
market and banking system flexible, all precious metal liabilities should be kept in precious
metals and up to %10 percent of foreign currency liabilities were allowed to be kept in precious
metals under Central Bank “standard gold” deposits. This policy is called Required Liabilities
Policy, which is aimed to meet the liquidity requirements of banks, the lending and borrowing
capacity and to increase the security. Simultaneously, this policy helps to maintain the price and
financial stability1. The money in the market affects the banks credibility. During the inflows to
the country, foreign investors are exchanging their investments to Turkish lira in order to be able
to invest and it increases the banks foreign exchange capacity. Also, if the required liabilities are
low, credit growth is accelerating. During the outflows and increased liabilities, the cost of
giving credit is increased leading to decreased growth of the credits. This policy makes it
possible to prevent the immediate economic decline by sterilizing the investments.

This new mechanism called Reserve Option Mechanism (ROM) aimed directly 2 issues: one of
them was to limit the adverse effects of Turkish lira volatility against foreign currencies and
second was to bring new horizon to the reserve requirements which was deducted to keep
economy stabile. Thanks to ROM, banks could keep allowed portion of liabilities in foreign
currencies and gold. The percentage which is measured to allow these liabilities is called Reserve
Option Ratio (ROR). The coefficients of Foreign Exchange and gold reserves are called Reserve
Option Coefficient (ROC)2.

Reserve Option Mechanism is captured in order to meet the Turkish Banking sector requirements
permanently in lower cost, to reduce the risk of the exchange rates spread and fluctuation, to be
independent of time for foreign exchange reserves by supporting them effectively and reduce
negative effects of high volatility of capital movements in macroeconomic terms3.

Graph 1.

1
Glocker,C. and Towbin, P.(2012) “Reserve Requirements for Price and Financial Stability: When Are
They Effective?”, International Journal of Central Banking, 8(1):p.65-114
2
Alper, K. , Kara, H. Ve Yorukoglu, M. (2012) “Reserve Option Mechanism”, CRBT Economic notes, 2012-28: p.22
3
Oduncu, A., Akçelik, Y. ve Ermişoglu, E. (2013) “Reserve Options Mechanism and FX Volatility”, Working Paper
No.13/03, CRBT, Ankara. p.67
Source: Alper, K. , Kara, H. Ve Yorukoglu, M. (2012) “Reserve Option Mechanism”

Graph 1 show the working mechanism of ROM. Let’s imagine that before the mechanism banks
had chance which was indicated by point A. During the FDI, as it is easy and cheap to access
foreign money liquidity, banks will benefit from ROM more by using some parts of foreign
investment for required liabilities. It will lead to move point A to the right. In this case, the
increase pressure on Turkish lira will decrease, by drawing down the exchange rates for foreign
currencies and stabilizing the fluctuation of the lira. During the outflows, the exchange rates for
the foreign currencies will go up. Banks will need currency liquidity; in which they will meet it
by reducing the reserve option. In this case, most of the liabilities will be provided by Turkish
liras which will boom the demand for lira and put a limit on devaluation.

Another benefit of Reserve Option Mechanism is that; it provides short term Turkish lira swap
transaction to banking sector. In this way, banks can meet their Turkish lira needs more rapidly
by currency exchanges. Followed by ROM benefit of limiting the growth of the foreign currency
loans, the currency volatility decreases and short-term capital flows reduce.

Reserve Mechanism must be used by banks in order to be able to take place as an automatic
balancer on the market and reach its intended targets. It seems that the banks are using this
mechanism in a high-order and stable manner. 12 of the banks which benefit of this mechanism
uses %55-60 of its ability, while remaining 21 banks are using %25-30 4.

4
CRBT (2012b) “Financial Stability Report”, Ankara.p.14
Reserve Option Mechanism also influences the CBRT's foreign exchange reserves. However,
gross foreign exchange reserves are increasing as there is no change in the net foreign exchange
reserves since the foreign reserves, which are held as required reserves, are not purchased by the
CBRT, but they belong to the banks. As of the end of 2011, the amount kept as foreign currency
for Turkish Lira required reserves increased from USD 10.3 billion to USD 27.2 billion as of
December 21, thus, the gross reserves of the CBRT reached approximately US $ 120.8 billion5.

The criticism of ROM

Although the interest rate corridor and reserve requirement policy developed by the CBRT as a
solution tool against the new economic situation, especially after the global financial crisis seems
to have succeeded in practice up to this time, there are some deficiencies in these tools. With the
policy of required reserves, financial and price stability are tried to be provided through lending
and exchange rate channels. The rise of credits and foreign exchange at this stage led to interest
rate being pushed to the second plan, while it was the most important instrument of traditional
inflation targeting policy. The interest rate instrument used in the inflation targeting policy in
Turkey was accepted by both public and financial circles, while changing tendency focused on
lending and foreign exchange have led to the wasted implementation of policies that were
accepted until this time. In this terms, the CBRT has had to make an extra effort for the new
vehicles to be accepted by the public again.

The adjustment of interest rates within the framework of the CBRT's interest rate policy
increased the uncertainty over interest rates and made it more flexible. Moreover, the fact that
interest rates are determined by the banks within the boundaries of the corridor rather than by the
decision of the Monetary Policy Committee, suggests that the CBRT has lost interest on interest
rates. The use of interest rate uncertainty as a tool is contradictory to the requirement of
transparency, which is one of the important preconditions of the inflation targeting policy. For
this reason, it has become imperative for the CBRT to share all its future operations with the
public in a timely manner, thus avoiding possible misunderstandings.

The CBRT has mixed these new instruments in order to ensure a more reasonable growth of
loans against the problem of rising current account deficit. However, loans are divided into

5
TCMB (2012c) “Year of 2013 Money and interest rate policy”, Ankara.p.12
investment and consumption credits. Despite the fact that consumption credits are a source of
consumption and current deficit, which is understood to be consumed, as from the name of
investment credits, investment credits have opposite characteristics. Investment credits are long-
term and large-volume credit types used for the supply of capital goods necessary for production.
The end result of these loans is that the economy is returning as production and value addition.
However, with this new policy amendment, the CBRT has adopted a policy of slowing the
growth rate of all loans without discriminating investment and consumption credits. This
situation will further reduce the rate of growth of the country to fall below the potential and other
macroeconomic problems (such as employment). Therefore, the CBRT's policy on credits should
be revised to try to slow the lending part of the loans, as well as try to increase investment loans.

The solution of financial problems in the European Union countries, which is the one of the
biggest export partners of Turkey after the global financial crisis, requires a long process. As a
result, the decrease in export revenues caused a decrease in the amount of foreign exchange that
came to the country. In addition to this decline, the cost of borrowing foreign currencies
increased, increasing the restrictions on foreign capital, which can cause businesses with a high
amount of borrowing capacity in foreign currency to have difficulty in paying their debts.

Conclusion

Due to globalization, neither of the countries in the world cannot isolate themselves from
economical, social and cultural developments. Turkish national economy has taken its share of
this crisis, despite the fact that the country was based on a solid macroeconomic basis since its
establishment. It is apparent that this new policy mix, which is applied in order to minimize the
effects of the crisis, has succeeded in examining the present results even in a very short and
countable historical period. Particularly, the main result is that ROM implementation has reduced
Turkish Lira volatility since the beginning. This practice has also created an effect in the foreign
exchange reserve management of the CBRT. In this way, the negative effects of financial
volatility on financial stability has been reduced. It can be stated that the CBRT is generally
successful in determining the problem and implementing the policy mix, although it is necessary
to pass a longer period in order to evaluate the effectiveness of the non-traditional policy
instruments during the crisis.
The fact that the secondary effects are still ongoing and that no one knows how long, it is clear
that this policy mix will continue for some time. It should not be forgotten that the success of the
policy mix will increase the efficiency of the CBRT in the liquidity management of the banking
sector. In this process, the policy of inflation targeting has been somewhat back warded, making
way to greater inflation rates. In the following stages, the CRBT should focus on the inflation
stabilizing economy by turning into chance next probable crisis.

Basically, this policy tool,

- Limits the credit growth which can be led from rapid capital inflows,
- In particular, limits the amount of credit that can be given in foreign currency from the
supply side,
- Both expands and collapse, in order to reduce its sensitivity to capital flows,
- Reduces the exchange rate volatility,
- Increases the gross foreign exchange reserves of the CBRT,
- Increase of the gross reserve in favor of the private sector will contribute to increasing the
durability and efficiency of the entire financial system, leading to more efficient use.

References:

1) Glocker,C. and Towbin, P.(2012) “Reserve Requirements for Price and Financial
Stability: When AreThey Effective?”, International Journal of Central Banking,
2) Alper, K. , Kara, H. Ve Yorukoglu, M. (2012) “Reserve Option Mechanism”, CRBT
Economic notes, 2012-28
3) Oduncu, A., Akçelik, Y. ve Ermişoglu, E. (2013) “Reserve Options Mechanism and FX
Volatility”
4) CRBT (2012b) “Financial Stability Report”, Ankara
5) TCMB (2012c) “Year of 2013 Money and interest rate policy”, Ankara.