TURKISH CENTRAL BANK:

Use of Interest Rate

as a Monetary Policy
Tool
 TURKISH CENTRAL BANK: USE OF INTEREST
RATE AS A MONETARY POLICY TOOL

Prepared For:

Syeda Mahrufa Bashar

Associate Professor

Institute of Business Administration

University of Dhaka

Prepared By:

Group 2

Syed Shams Arefeen (ZR-28)

Zahia Bakhtiar Khalid (RH-64)

Shaera Sayeed (RH-72)

Simran Tabassum Ali (RH-81)

Sartaz Bin Mustafiz (ZR-84)

BBA 24th

Date of Submission: 16th October, 2019

 LETTER OF TRANSMITTAL

16th October, 2019

Syeda Mahrufa Bashar

Associate Professor
Institute of Business Administration
University of Dhaka

Dear Madam,

We, the students of BBA 24th Batch, have prepared this report on “Turkish Central Bank: Use
of Interest Rate as a Monetary Policy Tool” which you had assigned to us as a section of the
course “Financial Markets and Institutions”. We have studied the articles and reports related to the
topic based on what we have understood through the theoretical concepts mentioned in our book.

This was both a challenging and enlightening experience as we have learnt concepts that will
immensely help us in the future. We are truly indebted to you for your support and kind regard in
this matter.

Please note that this report has been prepared under your supervision. Under no
circumstances will this report be produced for any other BBA (IBA) course ever. No part of
this report will be shared or republished without your authorization.

Sincerely yours,

Syed Shams Arefeen (ZR-28)

Zahia Bakhtiar (RH-64)
Shaera Sayeed (RH-72)
Simran Tabassum Ali (RH-81)
Sartaz Bin Mustafiz (ZR-84)
 Table of Contents

1. INTRODUCTION ................................................................................................................. 1

2. HISTORY OF CBRT ............................................................................................................ 1

3. INTEREST RATE THEORIES ........................................................................................... 2

3.1. Loanable Funds Theory........................................................................................................ 2

3.2. Liquidity Preference Theory ................................................................................................ 3

4. OUTCOME OF INTEREST RATE CUT ........................................................................... 3

4.1. Expected Outcome ........................................................................................................... 3

4.2. Actual Outcome................................................................................................................ 4

Cost Effect ........................................................................................................................ 4

Substitution Effect ............................................................................................................ 4

Announcement Effect ....................................................................................................... 5

5. TAKEAWAYS AND CONCLUSION ................................................................................. 6

6. REFERENCES ...................................................................................................................... 7
 1. INTRODUCTION

In 2018, the recession and the rising inflation rate wiped almost 30% of the value of the Turkish
Lira (Xinhua, 2019). In hopes to boost the recession-hit economy, the Central Bank of the Republic
of Turkey (CBRT) intervened to decrease the interest rates. The benchmark policy rate, which is
the one-week repo rate, was cut by 425 basis points (bps) from 24% to 19.75% in July 2019. As a
result, over the past year, the Turkish economy has seen the lowest level of inflation as consumer
prices moved from 24.52% in September 2018 to 9.26% in September 2019. This was mainly due
to lower demand, stable currency and fading effects of previous price rise.

2. HISTORY OF CBRT

The Central Bank of the Republic of Turkey (CBRT) was established as a joint stock company on
June 11th, 1930. CBRT enjoys instrument independence and determines at its own discretion the
monetary policies to adopt and the instruments to use to achieve its objectives.

The primary objective of CBRT was to achieve and maintain price stability and to achieve this
objective, CBRT has implemented a full-fledged inflation targeting regime since 2006. However,
after the global crisis in 2008-2009, one of the lessons learned was that ignoring financial stability
could adversely affect macroeconomic and price stability in the long term. Because of this, a
supplementary objective of financial stability along with the price stability was introduced by
CBRT at the end of the year 2010. In this period CBRT also diversified its policy instruments,
thus, using instruments like Required Reserves and Reserve Options Mechanism (Central Bank of
the Republic of Turkey, 2019).

CBRT has also introduced into the existing regime an asymmetric wide interest rate corridor
system in which more than one interest rate is used as an instrument. Although the wide interest
rate corridor used by CBRT has helped to reduce volatility in capital movements during periods
of global uncertainty, it has also involved problems concerning the understanding of monetary
policy stance. This was one of the reasons why the policy interest rate was reduced by 250 basis
points in the March-September 2016 period.

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Changes in the policy interest rates by CBRT affect price stability objectives through four main
channels as shown in the below diagram:

3. INTEREST RATE THEORIES

We have divided the series of events that caused the interest rate cut of 425 bps, into two relevant
theories:

3.1. Loanable Funds Theory

The currency and debt crisis of 2018 in Turkey involved high inflation, rising borrowing costs and
loan defaults, as well as a fall in the value of Turkish Lira. In Turkey, low savings rate have been
in existence for a long period. This phenomenon is likely to have caused the supply of loanable
funds in the economy to be low. Such inference can also be made since the current account in
Turkey’s balance of payments has been seeing a deficit amount.

It was deemed important to improve the current account balance in Turkey, and in order to increase
the level of exports, investments had to be encouraged. Such increase in investments would also

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allow the economy to recover well. This is the point where the domestic demand for loanable funds
would be required to rise and the fall in repo rate would help achieving the situation, because of
the negative relationship which exists between the two variables.

3.2. Liquidity Preference Theory

Based on this theory, the lowering of repo rates by the Turkish Central Bank may have an effect
on the transaction, precautionary and speculative demand. In case of the former, loans taken by
businesses through the low repo rates may help them in paying off other foreign-denominated
debts which were building up. Precautionary demand is prevalent in every economy, as citizens
demand liquid financial assets i.e. money for emergency expenditures. As for the speculative
demand, the fall in repo rates were likely to cause the value of the Turkish Lira to become a more
stable currency and also make holding money a much better option, because of the higher price of
and lower returns on bonds. Hence, a fall in the repo rate is likely to cause the transaction demand,
precautionary demand, and speculative demand for money to go up.

4. OUTCOME OF INTEREST RATE CUT

We have compared between the Central Bank’s expectations from the interest rate cut and the
reality in its aftermath:

4.1. Expected Outcome

The Central Bank’s decision to cut interest rates by 425 bps was consistent with the fact that
Turkey has been pursuing a monetary policy targeting inflation. This is mainly because the Turkish
President, Recep Tayyip Erdoğan, firmly believes that higher interest rates cause inflation, the
opposite of what classical economic theory states. (Ahval, 2019) According to the President,
producers pass on their higher borrowing costs to customers, which results in high prices.
(Bloomberg, 2019) Erdoğan has designed the economic policies of Turkey to follow his
unorthodox theory as well, and this is part of the process to reduce inflation, which is essential for
achieving lower sovereign risk, lower long-term interest rates, and stronger economic recovery.
(Ahval, 2019) The interest rate cut was also expected make loans cheaper, which would make
investment cheaper and lower the cost of production, which would in turn lower inflation and help

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boost economic growth (Yackley, 2019). Unemployment, on the other hand, was unlikely to
decrease.

Another expectation that the President had from the interest rate cut was that the Turkish Lira
would become stronger against the American Dollar (D, 2019). The Lira lost almost 30% of its
value against the Dollar and hit a record low of 7.2 per dollar in 2018 (Ahval, 2019). It is because
of this unstable currency that the inflation rate spiked in the first place. The interest rate cuts were
also expected to have a positive impact on Turkey’s failing construction sector, on which Erdoğan
had relied for a long time to boost economic growth. (Xinhua, 2019). According to Bloomberg
Economics, further rate cuts were expected in the future, which would result in inflation hitting an
all-time low in October 2019. (Daily Sabah, 2019)

4.2. Actual Outcome

The actual outcomes of the interest rate cut can be attributed to 3 types of effects:

 Cost Effect
The interest rate cut, which was assumed will accelerate the borrowing so that more reserves
flowed in to the banking system, was not effective. One hurdle was the dollarization trend
where people prefer other stable currencies over Lira. More than half of all deposits are now
non-Lira, which limits the banks’ ability to provide Lira loans and may not revive the economy
(Caglayan, 2019). Even though the rate cut had a positive impact on the economy, it is not
enough to return the country back to its desired level. More monetary stimulus and bank
lending will be needed to boost the economy.

 Substitution Effect
A change in the discount rate may cause other interest rates to change as well. Economists have
stated that the interest rate cut will be followed by a decline in the loan rates by state run
lenders.

July’s rate cut and expectations of further rate cuts thereafter helped bring loan and deposit
rates markedly down from the previous Monetary Policy Committee (MPC) period. (The
Central Bank of the Republic of Turkey, 2019) The interest rate cut has revived demand for
consumer loans and mortgages as the private banks also followed public banks in interest rate
cuts in consumer, housing and commercial loans. (Daily Sabah, 2019) The state-owned banks

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 Ziraat Bankasi, Vakifbank and Halkbank lowered rates on housing, consumer and corporate
loans (Caglayan, 2019), which will help the companies in their loan repayments and
restructurings. Consumer loans are rising amid cooperative credit packages and seasonal
requirements, while commercial loan growth, on the other hand, has remained unchanged due
to supply-side effects. (The Central Bank of the Republic of Turkey, 2019)

The Lira fell in the immediate aftermath of the announcement, then gained 0.9% to 5.68 per
dollar, outperforming other emerging market currencies and paring losses in 2019 to about
6.9%. (Ahval, 2019) Since then, it has maintained a fairly stable position in the currency
market. Turkish assets have been strengthened by a dovish tilt by the US Federal Reserve and
the European Central Bank that has fuelled investor appetite for riskier emerging market
assets. (Pitel, 2019)

 Announcement Effect
The interest rate cut exceeded the market expectations. The median expectation by economists
was for a cut of 250 basis points, which was way below the actual cut of 425 basis points
(Taner, 2019). Analysts now expect a deeper contraction in the third quarter of 2019 and the
borrowers may decelerate on their borrowings and may wait for periods of lower interest rates.
The view of rate cuts may be positive now but if Turkey-specific risks increase then the view
may change.

So far the interest rate cuts have been successful in achieving their short-term goals. The interest
rate cut, along with the stable performance of the Turkish Lira, and falling prices have led to a
sharp decrease in inflation, which is now below 10% for the first time in 26 months. (Daily Sabah,
2019) The rate cut and the subsequent decline in housing loan rates have also led to a rise in
confidence in the construction sector, as Erdoğan had expected. The Construction Sector
Confidence Index reached the highest level of 60.1% in September, and there is mobility in the
industry. (Daily Sabah, 2019) Property sales have also increased by a 5.1% annual rate in August
2019, after seven consecutive months of decline. (Daily Sabah, 2019)

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 5. TAKEAWAYS AND CONCLUSION

According to us, the biggest takeaway from this assignment was the fact that classical
macroeconomic theories may not hold true in every case. We have always learnt that lowering
interest rates lead to inflation, due to increased purchasing power. But in the case of Turkey,
exactly the opposite has happened and instead, the economy has flourished. On the other hand, we
have also seen our theoretical learning come true in a practical scenario as we saw the actual impact
of the interest rate cuts in terms of the cost, substitution, and income effects of an interest rate
change.

For the most part, the Turkish President was right in his decision to cut interest rates. It is because
of this that the interest rate cut in July 2019 led to another interest rate cut of 325 bps in September
2019, because the CBRT had seen success in interest rate cuts. But then again, according to experts,
in Turkish monetary policy, there is always the risk that the rate cuts may push real rates to levels
that ultimately turn out to be too low to support the Lira. Interest rate cuts are part of a cycle of
events and there is always the possibility that the cycle may turn again. The markets and the public
may think of rate cutting as a macroeconomic tool having more positive effects than negative, but
if the global scenario shifts, or risks arise in Turkey again, their view of rate cuts can easily change.

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 6. REFERENCES

Ahval, 2019. Erdoğan writes unorthodox interest rate theory into economic blueprint. [Online]
Available at: https://ahvalnews.com/turkey-economy/erdogan-writes-unorthodox-interest-rate-theory-
economic-blueprint

Ahval, 2019. Erdoğan's offbeat interest rate theory empowered after inflation slows. [Online]
Available at: https://ahvalnews.com/turkey-economy/erdogans-offbeat-interest-rate-theory-
empowered-after-inflation-slows

Ahval, 2019. Turkey’s central bank cuts benchmark rate by 425 basis points to 19.75 percent. [Online]
Available at: https://ahvalnews.com/central-bank/turkeys-central-bank-cuts-benchmark-rate-425-basis-
points-1975-percent

Ahval, 2019. Turkish lira rises to two-week high as slower inflation backs rate cut. [Online]
Available at: https://ahvalnews.com/turkish-lira/turkish-lira-rises-two-week-high-slower-inflation-backs-
rate-cut

Bloomberg, 2019. Turkey's new central bank head announces heavy interest rate cut. [Online]
Available at: https://www.thenational.ae/business/economy/turkey-s-new-central-bank-head-
announces-heavy-interest-rate-cut-1.890649

Caglayan, C., 2019. After sharp rate cut, Turkey's crisis-hit companies seek more stimulus. [Online]
Available at: https://www.reuters.com/article/us-turkey-economy-loans/after-sharp-rate-cut-turkeys-
crisis-hit-companies-seek-more-stimulus-idUSKCN1US1L5

CBRT, 2016. CENTRAL BANK OF THE REBUPLIC OF TURKEY. [Online]

Available at: https://www.tcmb.gov.tr/wps/wcm/connect/cccae9f9-4f60-4921-95bd-
952e100d22ff/CBRT_Factsheet.pdf?MOD=AJPERES&CVID=
[Accessed 7 October 2019].

Central Bank of the Republic of Turkey, 2019. Central Bank Monetary Policy Framework. [Online]
Available at:
https://www.tcmb.gov.tr/wps/wcm/connect/EN/TCMB+EN/Main+Menu/Core+Functions/Monetary+Pol
icy/Central+Bank+Monetary+Policy+Framework
[Accessed 7 October 2019].

Daily Sabah, 2019. Inflation hits single digits for first time in over 2 years, drops to 9.26%. [Online]
Available at: https://www.dailysabah.com/economy/2019/10/04/inflation-hits-single-digits-for-first-
time-in-over-2-years-drops-to-926

Daily Sabah, 2019. Interest rate cuts boost confidence, bring mobility in construction industry. [Online]
Available at: https://www.dailysabah.com/finance/2019/09/30/interest-rate-cuts-boost-confidence-
bring-mobility-in-construction-industry

Daily Sabah, 2019. Property sales rise 5% in Turkey in August after July rate cut. [Online]
Available at: https://www.dailysabah.com/real-estate/2019/09/18/property-sales-rise-5-in-turkey-in-
august-after-july-rate-cut

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Daily Sabah, 2019. Rate cuts revive markets, revitalize consumer loan, mortgage demand. [Online]
Available at: https://www.dailysabah.com/finance/2019/09/20/rate-cuts-revive-markets-revitalize-
consumer-loan-mortgage-demand

Daily Sabah, 2019. Surveys forecast sharp tumble in September inflation. [Online]
Available at: https://www.dailysabah.com/economy/2019/10/02/surveys-forecast-sharp-tumble-in-
september-inflation

D, S., 2019. Turkey Central bank will lower interest rate further, says Erdogan. [Online]
Available at: https://www.financial-world.org/news/news/economy/2804/turkey-central-bank-will-
lower-interest-rate-further-says-erdogan/

Pitel, L., 2019. Turkish central bank slashes interest rates. [Online]
Available at: https://www.ft.com/content/a3d5da28-aecb-11e9-8030-530adfa879c2

Taner, B. S., 2019. Turkey central bank seen making deeper rate cut on July 25 - Reuters poll. [Online]
Available at: https://www.reuters.com/article/uk-turkey-cenbank-poll/turkey-central-bank-seen-
making-deeper-rate-cut-on-july-25-reuters-poll-idUKKCN1UE17E

The Central Bank of the Republic of Turkey, 2019. Press Release on Summary of the Monetary Policy
Committee Meeting. [Online]
Available at: https://www.tcmb.gov.tr/wps/wcm/connect/6a910c46-cf86-48da-bab4-
223359779d4a/ANO2019-37.pdf?MOD=AJPERES&CACHEID=ROOTWORKSPACE-6a910c46-cf86-48da-
bab4-223359779d4a-mR9bs-x

Xinhua, 2019. Turkey sharply cuts interest rates to stimulate ailing economy. [Online]
Available at: http://www.xinhuanet.com/english/2019-07/26/c_138258182.htm

Yackley, A. J., 2019. Turkey slashes interest rates to kickstart economy. [Online]
Available at: https://www.al-monitor.com/pulse/originals/2019/09/turkey-slashes-interest-rates-
kickstart-economy.html

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