Alternative Tools to Manage Capital Flow Volatility

Heightened volatility in cross-border capital flows has increased exchange rate volatility across emerging markets as well as in advanced economies, setting the stage for more active management of currencies. Traditionally, foreign exchange rate intervention has been the primary tool to address these types of challenges. However, given the limitations of foreign exchange rate intervention, it may be well worthwhile to explore alternative mechanisms for dealing with capital flow volatility. This paper explains how the new policy framework adopted by the Central Bank of the Republic of Turkey (CBRT) in the past two years has eased the need to conduct FX interventions. We first describe the rationale for the new policy framework, which is an augmented version of inflation targeting, with more emphasis on macro financial risks. Next, we explain the new instruments developed by the CBRT and their contribution to coping with capital flow volatility. In particular, we focus on the Reserve Option Mechanism, which is designed as a shock absorber for volatile capital flows, and thus reduces the need for FX intervention. We demonstrate that, since the adoption of new policy tools, the volatility of the Turkish lira has been remarkably low in comparison with the currencies of peer economies.