Monetary Policy

Turkey’s currency initially rallied after the central bank raised interest rates yesterday. Perhaps a bit more orthodoxy is all it will take to restore a modicum of stability to Turkey’s markets. Then again, the lira’s rally didn’t last long. Even if Turkey firmly commits to a somewhat more orthodox monetary policy, Turkey retains substantial vulnerabilities: Turkey’s current account deficit was quite large even before oil rose to $80, and Turkey imports a ton of oil (and natural gas). Turkey has a dollarized financial system and trades heavily with Europe. It thus doesn’t benefit much from the rise in imports that Trump’s fiscal stimulus has generated, but gets hurt by higher interest rates on its dollar borrowing. Turkey has a decent stock of external debt, and much of that is denominated in foreign currency. Turkey’s banks lend domestic dollar deposits to Turkey’s firms, who have more foreign currency debt than they have external debt. And, Turkey could use a few more reserves.  Turkey's reserves fall far short of covering its external financing need over the next year. There are three important things to know about Turkey’s foreign exchange reserves. A lot of Turkey’s reserves are in gold and thus not in dollars or euro. Turkey’s debts though don’t settle in gold. A lot of Turkey’s reserves are borrowed from the domestic banks, who can meet their reserve requirement on lira deposits by posting either gold or foreign exchange to the central bank.  Most of the gold, and a decent chunk of the foreign exchange, is effectively borrowed. That limits the pool of funds available to intervene directly in the foreign exchange market (though it also provides the banks with a bit of a buffer). Turkey’s reserves don’t come close to covering its maturing external debt, let alone its external financing need, no matter how you cut it. Turkey has about $180 billion in external debt coming due (around $100b from the banks, $65b from firms).* It has a $50 billion (give or take) current account deficit. That’s a one-year external financing need of close to 30 percent of Turkey’s pre-depreciation GDP, against 12 percent in total reserves and about 10 percent of GDP in foreign exchange reserves. And the bulk of Turkey’s maturing external debt is denominated in a foreign currency—it thus is a claim on reserves that cannot be depreciated away. On classic measures of external vulnerability, Turkey—like Argentina–– is much more under-reserved than the IMF’s reserve metric would suggest (M2 and exports aren’t large versus GDP, so they pull the reserves Turkey’s needs to meet the IMF's standard well below maturing short-run debt). And even if it is graded on the IMF’s generous curve, Turkey falls short (See paragraph 19 of the IMF’s latest staff report). These vulnerabilities aren’t new. Turkey has long looked vulnerable to an Asian style financial crisis—one triggered by a loss of access to bank funding and a bank-corporate doom loop from the private sector’s foreign currency debts. And it has some of Argentina’s old vulnerabilities too, with roughly $200 billion in domestic foreign currency deposits (data from Turkish Central bank)) in addition to $400 billion plus in external debt (see this classic book on emerging market crises for background on the Asian and Argentine crises). These long-standing vulnerabilities haven’t triggered a full-on crisis yet. Turkey’s domestic deposit base and its external funding has historically been fairly sticky.   It has been surprisingly resilient in the past. Yet there are reasons to think Turkey faces a more difficult challenge now. U.S. rates are rising when oil is going up, and that’s a bad combination for an oil importer with lots of dollar debt. While Turkey has long looked bad on classic indicators of external vulnerability, it now is starting to look really bad—short-term debt has jumped a bit relative to GDP (thanks mostly to a surge in corporate borrowing, which shows up in the “trade credit” line) and the external funding need is now close to three times liquid (non-gold) foreign exchange reserves. Turkey though differs from Argentina in one critical respect. Its government hasn’t been the biggest external borrower, and it doesn’t have the biggest stock of foreign currency debt in the economy. That honor goes to Turkey’s firms, who have almost $340 billion in foreign currency denominated debt ($185 billion is owed to domestic creditors, and $150 to external creditors—$110 in loans and $40 in trade credit [source]). The quality of their hedges will be tested: I never have been convinced all foreign currency debt is really backed by export receipts. What really makes Turkey interesting, though, is its banks. They have a rather fascinating balance sheet and engage in some fairly creative forms of financial intermediation, with a bit of regulatory help. The core problem Turkey’s banks face is simple. Turks want to hold a large chunk of their savings in dollars. And foreigners want to lend to Turkey in dollars (or euros). But Turkish households want to borrow in lira (in fact the banks cannot lend to households in foreign currency—a sensible prudential regulation). So the Turkish banking system has a surplus of foreign currency funding—and a shortfall in lira funding. There is an easy way to see this. Look at the loan to deposit ratio in foreign currency. It’s clearly below 1, about 0.8. And then look at loan to deposit ratio in lira. It is well above 1—it is now about 1.4. (See the IMF’s 2016 staff report [Paragraph 46], or the most recent financial stability report of the Central Bank of Turkey, starting on p. 50. Chart III.2.4 on p. 51 has the loan to deposit ratio by currency).** So how do the banks transform dollars into lira? A couple of tricks: They swap a lot of dollars into lira. Fair enough. But the tenor of the swaps is fairly short (see box III.2.1 of the central bank’s financial stability report . The “lira” can run even if the dollars raised by selling longer-dated bonds cannot.) And the central bank lets the banks meet their reserve requirement in lira by posting foreign exchange or gold at the central bank (so gold deposits in effect fund lira lending, indirectly). This means the banks have a decent buffer of foreign exchange—which they can draw on if their creditors start to withdraw funding. One secret source of strength of the system is that the banks themselves have a fairly large stockpile of foreign exchange deposits that matches their large short-term external debts.*** Makes for a strange system. So long as the domestic hard currency deposits don’t run, the banks ultimate funding need is in lira. In addition to transforming foreign exchange funding into lira lending, the banks do a lot of classic intermediation—borrowing short-term (there aren’t lots of sources of long-term lira funding) to fund lira denominated installment loans and mortgages. The banks consequently are exposed to an interest rate shock—in much the same way the U.S. savings and loans were back in the 1970s (they funded long-term mortgages with short-term deposits). This has a plus—raising domestic interest rates sharply would quickly slow bank lending and reduce demand, helping to close the current account deficit. But it also encourages a lot of creativity on the part of the central bank, which knows—I think—that the banks ultimately rely on it for lira funding and are vulnerable to an interest rate shock. And historically at least, the regulators have often preferred to use macroprudential limits to cool the economy rather than rate hikes, though it isn’t clear if that would be enough right now. Bottom line: Turkey cannot really use its reserves to try to defend the lira. Selling off some of its already limited reserves to cover an ongoing current account deficit would create the perfect conditions for a run on the banks’ foreign currency liquidity to develop. A free fall in the lira would cause corporate distress, even if it would take a lot to really threaten the government’s solvency. And raising rates sharply would squeeze the banks ability to lend—slowing the economy, but helping to close the current account deficit. Pick your poison. * Thanks to $120 billion or so in short-term external debt and the scheduled roll off of a fraction of its long-term claims. ** The CBRT (emphasis added): “Depositors’ FX deposit preferences and the change in favor of the TL in the loan composition of banks led to a widening in the gap between the TL and FX L/D ratios. The difference between TL and FX L/D ratios indicates that banks need TL liquidity. As a result of depositors’ FX deposit preferences and banks’ TL liquidity needs increased FX swap transactions with foreign residents. Therefore, the amount, maturity, cost and counterparty structure of FX swap transactions have recently become important with respect to monitoring the liquidity risk of banks.” *** It helps that domestic depositors tend to switch out of lira and into domestic foreign currency deposits in periods of stress. The banks can absorb a loss of external funding for a while (they likely have something like $50 billion in liquid assets at the central bank, and presumably could borrow against their gold too) but not a simultaneous loss of external funding and a run on their domestic dollar deposits.  

The IMF’s reserve metric tends to overstate the reserve needs of current account surplus countries with little external debt, and understates the reserve needs of current account deficit countries with lots of external debt.

The Treasury's April foreign exchange report should be interesting. Thailand hasn't been included in past foreign exchange reports.  Yet it is likely to meet all three of the criteria set out in the Bennet Amendment for a finding of "manipulation." 

“I am confident that the apparent disconnect between growth and inflation is a temporary phenomenon,” said ECB executive board member Yves Mersche on December 6. The “deep downturn” in the Eurozone economy, he explained, had “led to broader slack in the labor market” not captured in the unemployment data. As that slack dissipates, inflation will pick up. Is he right? The so-called Phillips curve phenomenon in economics holds that, all else being equal, a fall in unemployment should lead to a rise in inflation. That relationship has been subjected to much critical theoretical and empirical scrutiny over recent decades. We investigated how well it has held in the Eurozone since 2008, at the beginning of the financial crisis. As the top left graphic shows, the relationship is weak. Falling unemployment is not materially boosting inflation. But when we broaden the analysis to encompass the phenomenon alluded to by Mersche—the existence of a hidden army of “discouraged workers,” not reflected in the unemployment data, who hold down inflation even as the unemployment rate falls—the relationship becomes much stronger. This can be seen clearly in the top right graphic. The lesson is that the Phillips curve is alive and well, but only when falling unemployment is understood more broadly as rising labor force participation (LFP). This fact suggests that the Fed is also right to expect inflation to rise as the labor market continues to tighten, but that it is the LFP rate that sends the clearest signal on timing.

The Trump Administration wants to bring down the U.S. trade deficit. A number of manufacturing-heavy Asian economies run sizable current account surpluses. Over the course of the summer, some of them were clearly intervening to keep their currencies from rising against the dollar. But, somewhat surprisingly, this hasn’t caught the attention of the Trump Administration. The latest Treasury foreign exchange report removed Taiwan from the Treasury watch list even though Taiwan intervened over the summer to keep the New Taiwan Dollar from rising (at the 30 Taiwan dollars to the U.S. dollar mark). The report didn’t display any noticeable irritation at Korea’s continued propensity to buy dollars to keep the won from strengthening through the 1100 Korean won to the dollar mark. Korea bought foreign exchange in July, before the North Korean missile crisis intensified. The report continues to ignore Thailand, even though Thailand comes very close to meeting all three of the Treasury’s stated criteria for identifying manipulators (a bilateral surplus with the U.S. of over $20 billion, an overall current account surplus of more than 3 percent and intervention in excess of two percent of GDP). And Singapore got yet another free pass. These countries, not China, are at the epicenter of the recent return of foreign exchange intervention in Asia. India and Indonesia have also intervened, but they get off because they run current account deficits.* If you think countries with large current account surpluses shouldn’t be intervening in the foreign exchange market to help keep their currencies weak, there is plenty to complain about right now—more so than at any time since the dollar’s late 2014 appreciation. The combined current account surplus of these smaller Asian economies ($250 billion) is up substantially from 2007, and for that matter from 2012. And practically speaking, currency moves have a fairly predictable impact on the trade balance—convincing a number of Asian countries to let their currencies appreciate would likely have a more significant impact on the U.S. trade deficit than Trump’s high profile attempts to renegotiate existing trade agreements.  Centering the Treasury’s report around the three criteria set out in the Bennet amendment has strengthened the report’s analytical underpinning. At times in the past the report veered a bit too far from actual developments in the foreign exchange market—particularly in its description of the policies of individual countries. But I suspect that applying the three criteria too mechanically creates problems of its own—not the least because it is relatively easy for a country that is paying attention to engineer around the reserve accumulation criteria. At risk of intervening too much? Get your social security fund to buy a bunch of foreign assets in a new “diversification” push. Or have the finance ministry issue local currency bonds to set up a sovereign wealth fund that will buy foreign exchange from the central bank on an ongoing basis. Or let your forward book rollover directly to your sovereign wealth fund. Or ask your state banks to buy foreign exchange and provide them with an (undisclosed) hedge. I didn’t make any of the examples above up. The irony is that the more experience a country has with intervention, the easier it often is to hide the intervention. Concretely, I think the Treasury should make five adjustments to the foreign exchange report. (1) Assess more countries against the Bennet criteria. This one is easy. Expand the report to the top twenty trading partners. And automatically assess any country with its own currency and a current account surplus of over 3 percent of GDP. There is no good reason why the foreign exchange report right now doesn’t cover Thailand—which is less than $1 billion dollars away from meeting all three Bennet criteria (its bilateral surplus with the U.S. is $19 billion and change). (2) Deemphasize the bilateral balance. This one is a little tricky. The Trump administration has made the bilateral balance a key measure of trade success (it isn’t, especially in a world where bilateral trade is often heavily motivated by tax concerns. The focus right now is on goods trade, but the bilateral services data is even more problematic: the U.S. runs a healthy services surplus with Ireland and the “UK Caribbean”).** And well, the bilateral balance criteria is mandated by Congress: the Treasury cannot legally toss it aside entirely. But the bilateral balance currently has the effect of letting some countries that should get more scrutiny off the hook. Taiwan for example. Its bilateral surplus with the U.S. doesn’t breach the $20 billion threshold even though its overall current account surplus easily tops 10 percent of its GDP. Taiwan produces a ton of semiconductors (some based on licensed designs, with the royalties paid—I would guess—in no small part to the offshore subsidiaries of U.S. multinationals for tax purposes; some based on Taiwanese intellectual property) that are sold to Chinese firms that assemble electronics for reexport. Taiwan’s value-added bilateral surplus is far higher than its reported bilateral surplus with the U.S. The same is true of Korea. Korea now exports more semiconductors than autos. But the bilateral trade data shows only limited U.S. imports of Korean semiconductors (and for that matter, only modest imports of smart phones). Korean electronic components are often assembled elsewhere for re-export globally. And making a deficit in bilateral trade one of the currency report’s three criteria has let Singapore permanently escape the scrutiny its heavy intervention deserves, as Singapore runs a bilateral surplus with the U.S.*** Singapore is small, but its currency policy has long set a bad example for its neighbors.  (3) Stop giving countries a free pass on a large existing stock of reserves. Right now the Treasury deducts estimated interest income on a country’s existing stock of reserves from its estimate of intervention. That has the effect of giving a country like Taiwan—with reserves equal to 80 percent if its GDP—a pass on reserve growth of about one percent of GDP, if not a bit more. In my view, countries with high levels of reserves and large current account surpluses should be encouraged to sell the interest income for domestic currency and in turn use the domestic currency to pay the interest on their sterilization instruments or to remit profits back to the finance ministry. In Taiwan and Korea that would provide a revenue stream that could be used, for example, to pay for expanded social insurance. Counting interest income toward the two percent reserve growth threshold also is a way of recognizing that a large stock of reserves from past intervention has an impact on the current account (as Dean Baker emphasizes) not just intervention today. (4) Do not ignore the exchange rate at which a country intervenes. At 1100 won to the dollar, Korea generally runs a large current account surplus globally, and will export a ton of autos to the U.S. At 900 won to the dollar, Korea ran a much more modest surplus globally, and Korean auto makers have a strong economic incentive to produce in the U.S. rather than in Korea. The right level of the won to the dollar of course depends a bit on Korea’s own economic conditions and a bit on the dollar’s overall strength or weakness. But if the won is being kept too weak against the dollar, it is likely to be too weak against most currencies most of the time. The Treasury currently just looks at the quantity of intervention, not the timing of the intervention – and it doesn’t assess whether a country is stepping into the market at the right or the wrong level. The Treasury’s October report, for example, lauds Korea for reducing its intervention (the lower level of intervention is a function of large sales last fall when the dollar was appreciating strongly and Korea faced significant political uncertainty, Korea has resisted appreciation pressure by buying dollars at various points this year). But last I checked, Korea continues to have a policy of intervening to block appreciation when the won approaches 1100. And intervening at 1100 is a step backward in the grand scheme of things. In the years before the crisis, Korea waited for the won to appreciate to 900 before intervening (that was Korea’s policy in 2006 and 2007) and at times after the crisis it has waited for the won to approach 1000 before stepping in (admittedly, the won only reached 1000 once, in 2014; Korea usually stepped in at the 1050 mark). Looking at objective criteria like the amount of intervention was meant to take subjective judgments about the “right” level of the currency out of the report. I don’t think it works. Intervention at the wrong level should be called out even if it isn't big enough to cross the "sanctionable" threshold, particularly in a context where the government is actively encouraging a broad range of domestic investors to buy foreign currency. (5) Stop ignoring shadow intervention (e.g. the accumulation of foreign assets by actors other than the central bank).**** Here is a prediction: China, Korea, Taiwan, and Japan will never “show” reserve growth in excess of two percent of GDP when they meet the other two criteria for being named. It is too easy to shift foreign exchange off the central bank’s balance sheet and onto the balance sheet of other state actors. Korea for example has decided to invest a large share of the assets of its national social security fund abroad (the national social security fund is already huge, and—thanks to Korea’s high contributions and miserly social benefits—adding rapidly to its assets). Call it diversification if you want. It clearly has had the effect of structurally reducing Korea’s need to intervene in the foreign exchange market. Japan’s government pension fund has a huge pool of domestic assets that it could sell (to the central bank) in order to invest abroad if Japan had reason to be concerned about yen strength. China’s Belt and Road Initiative was originally designed, in part, to help the PBOC reduce its headline reserve growth—though it has subsequently taken on a life of its own. And Taiwan has encouraged outflows from its life insurers on a rather massive scale. I would be a bit surprised if they don’t have an explicit or implicit hedge with the government. The growth in their holdings of foreign debt mechanically has explained how Taiwan has been able to keep its intervention limited even with a massive surplus. Taiwan's financial institutions now hold almost as much foreign debt as Taiwan's central bank, and clearly have been doing most of the recent buying.**** In many ways this is the right time to try to establish a new global norm, one where countries with large current account surpluses don’t intervene to block appreciation—or encourage their state institutions to diversity into foreign assets—to help keep the currency weak. Korea, Singapore, Taiwan and Thailand all have current account surpluses of over five percent of their GDP; Singapore, Taiwan and Thailand have current account surpluses of over ten percent of their GDP (over the last four quarters of data). Setting out the norm when most countries are in violation of it is difficult, practically speaking. Better to spell out it out ahead of time and give countries a chance to adjust. That’s why the October report was a missed opportunity. The Treasury took the heat off just when several countries should have been put on notice for their intervention over the summer. * Switzerland has intervened heavily at times this year too, but the euro’s recent appreciation has taken a bit of pressure off the Swiss National Bank. ** The bilateral services trade is in its own way quite interesting. The U.S. runs a massive bilateral services surplus with Ireland, and an (admittedly small) deficit with Germany (a world renowned center of service excellence obviously!). The U.S. runs a massive surplus with the UK Caribbean (primarily in financial services) and to my surprise, a massive deficit with Bermuda (it is all due to reinsurance). It also runs a surplus with places like Switzerland and Singapore. That is why I suspect the bilateral services trade data is even more distorted by tax considerations than the bilateral goods data. (country numbers are from the U.S. services trade data, table 2.3) *** I would guess in part for tax reasons. Singapore is a hub for petrol refining, pharmaceutical manufacturing, and semiconductor manufacturing and testing. And well, the import and and re-export of Australian iron, which clearly is tax-driven. **** In some countries, like Japan, the finance ministry manages the bulk of the country’s formal reserves. But even in these cases there are ways of shifting foreign asset accumulation to less scrutinized institutions. ***** Since 2011, "private" holdings of portfolio debt—according to Taiwan's net international investment position data—have increased from 35 to about 80 percent of Taiwan's GDP. That's a lot of foreign exchange risk for domestic institutions to hold.

Often one of the best ways to get noticed is to highlight something a bit surprising. A data point that doesn’t match expectations for example. Puerto Rico’s large trade surplus for example, which, really is “fake” news: it is rather obviously a function of transfer pricing that helps pharmaceutical firms shift profits offshore, where they can be indefinitely tax-deferred. But it also is important to remember that many things play out more or less as expected. Here are three that have caught my eye: 1. Capital flows to emerging market commodity exporters have been pro-cyclical. Not exactly news, but important. Most emerging economies are commodity exporters, and most pay more to borrow when commodity prices are low. That makes it harder to smooth commodity price volatility by borrowing from abroad—and makes it more important for commodity exporters to have a buffer stock of assets (or a flexible currency). (A hat tip to Peterson’s Chad Bown for highlighting this VoxEU paper by Thomas Drechsel and Silvana Tenreyro). Now perhaps this is changing. The IMF’s global financial stability report is worried that the global reach for yield may have gone a bit too far.* And I have certainly been struck by the large sums many Gulf countries have borrowed recently. But these countries may be the exception that prove the rules. The Emiratis, the Qataris, and the Saudis all have substantial assets stockpiled either in their central banks’ foreign exchange reserves or in their sovereign funds. They are in a sense borrowing to avoid selling their assets—rather than borrowing “naked” to finance the deficits created by the fall in oil prices.** 2. Tight fiscal policy often contributes to large current account surpluses. The latest IMF revisions to Korea’s fiscal stance offer a case in point (the Korean article IV has been delayed it seems, but the WEO provides updated numbers). It turns out that Korea’s 2016 fiscal policy was tighter than that of Germany. Germany’s structural surplus was 1 percent of GDP, while Korea’s was 2 percent of GDP. The IMF also now believes there was significant structural tightening in 2016 as well (something I am not sure either the IMF or the Treasury noticed in real time; the Koreans have done a lot of “fake” stimulus). The IMF has taken note of the government of Korea’s substantial assets--Korea’s net debt is about 5 percent of GDP. I suspect the IMF added the social security funds’ assets to its calculations of net debt. Korea’s 2016 fiscal tightening was thus globally unhelpful. It drained the world of demand when the world was short of demand. That put pressure on countries with weaker public balance sheets to do more to support demand. And it of course also contributed to the weaknesses in Korea’s economy that led the Bank of Korea to ease—and at times to intervene directly in the foreign exchange market to cap won strength. The IMF’s fiscally driven current account model doesn’t always work well (China’s credit boom and large fiscal deficit for example sits oddly with its balance of payments surplus). But for Korea, it captures a large part of the story—especially because the social security fund’s accumulation of foreign assets provides a direct link between Korea’s structural surplus (a function of high contributions to the social security fund) and capital outflows. 3. China’s export machine is still strong, and it still responds to changes in the real exchange rate The IMF estimates that world import demand (and world exports) will grow by about 4 percent this year (for goods). China’s export volumes are, according to the (not ideal) Chinese data up about 8 percent.*** So Chinese export growth once again will exceed global export growth (Chinese import growth is more or less in line with China’s growth, or a bit faster than China’s growth, which is good news—and a bit of a change). That’s why I am generally skeptical about stories that suggest China is losing its competitive edge in manufacturing: it may be true in some narrow sectors, but it simply isn’t borne out in the global data. And, well, a pick-up in Chinese export growth after a close to 10 percent real depreciation is more or less what a standard trade model would forecast. The yuan’s 2016 fall certainly seems to be having an impact on China’s 2017 export performance. Basically, when the yuan rose strongly in 2014, Chinese export growth slowed to match global export growth (a change for China). And the 2016 depreciation seems to have helped push Chinese export growth above global export growth—which is more or less the “norm” for China. And that recovery in exports, along with tighter controls and a broader rebound in economic activity all have helped to stabilize China’s currency’s for the time being.   * The Fed’s balance sheet expansion since 2010, has, according to the IMF’s global financial stability report, explained a sizeable share of portfolio flows to emerging economies—about a half of the roughly $350-400 billion total in the data set, with fed policy expectations also contributing significantly to inflows (p. 21, and figure 1.15: model estimates indicate that about $260 billion in portfolio inflows since 2010 can be attributed to the push of unconventional policies by the Federal Reserve). I applaud the effort to quantify portfolio balance effects. But I also thought there was something a bit strange about the results of the IMF’s attempt to quantify the impact of balance sheet expansion on emerging market flows. The study focused entirely on the Fed, but—as Figure 1.13 on p. 19 shows—the Fed’s quantitative easing hasn’t been nearly as significant, relative to government bond issuance and thus to the available supply of bonds, as ECB and BoJ balance sheet expansion. Maybe there is a massive asymmetry here: ECB QE is bad for emerging markets flows because it induces inflows into the U.S., raises the value of the dollar and thus indirectly hurts emerging markets because they tend to borrow more in dollars than in euros or some such? But it isn’t obvious to me why the effect of ECB and BoJ QE should fundamentally differ from the effect of U.S. QE. At the end of the day, Europe and Japan are net savers and thus the ultimate supplier of funds—and QE in Europe and Japan has worked in part by reducing domestic yields and thus encouraging investors to reach for yield abroad (see Coure’s speech in July). ** Technically, their debts reduce their net asset position, rather than add to a net debt position. *** China reports the y/y growth in its exports monthly, but doesn’t report an estimated level. I took the average of the available y/y changes. The y/y numbers can be volatile because of shifts in the timing of the lunar new year, but the monthly volatility tends to offset (a big fall in February means a big rise in March or vice versa).