Central Bank of Turkey: much ado about nothing

Central Bank Governor Murat Çetinkaya has finally announced measures to address more than $200 billion of foreign debt owed by Turkish companies, which investors have for years cited as a major weakness of the economy.

Rather than raising interest rates to arrest a slide in the lira – a political “no, no”, for the government -- the central bank announced a series of measures over the past two weeks to help reduce the credit burden on firms and stem weakness in the currency.

Firstly, the central bank tried to ease the foreign exchange burden on banks and the real sector last week through a modification to the reserve requirement ratio. In essence, it allowed banks to pay for $5 billion in rediscount credit payments due by Feb. 1, 2018 at 3.70 lira per dollar and 4.30 per euro, below current market rates. The bank’s decision to guarantee such a level for the lira was widely criticised throughout the week, as it was seen as a means of trying to  tinker with foreign exchange values and avoid a rate increase.

Secondly, this week, the central bank said it would seek to help the corporate sector to better manage its mounting exchange rate risk by introducing “non-deliverable foreign exchange forward transactions”. This tool allows the difference between forward exchange rates set on the contract day and the spot rate on the settlement day to be repaid in Turkish lira. These transactions will be conducted by auctions among the banks that are members of the foreign exchange market; and the central bank thinks that such direct trade will also decrease transaction costs.

Foreign debt of Turkish corporates
Private sector loans from abroad (source: central bank)

Deputy governor Erkan Kilimci also mentioned that the bank would introduce a “Systemic Risk Data Monitoring Model” that will analyse the exchange rate risk of corporations. Firm by firm across Turkey, the bank is creating a broad data set to monitor: i) FX positions, ii) cash flows, and iii) the use of derivative products. Kilimci also mentioned a draft law “under consideration” that will improve the effectiveness of data collected from corporations so that the exchange rate risk can be better managed.  

In summary, the central bank is gearing up for further volatility in the value of the lira in the coming days (and perhaps months), and trying to prevent firms from becoming severely affected by such fluctuations, which could lead to “mass bankruptcies,” as forewarned by ratings agency JCR this week.

The bank, however, optimistically envisages a “resilient corporate sector, despite its heavy forex debt burden, that will be focused on medium to long-term decisions”, rather than one that gets smashed by short-term lira volatility.  

interest rates in Turkey, selelcted (source: CBRT)
interest rates in Turkey, selelcted (source: CBRT)

Deep down, still being an inflation-targeting institution, the central bank is of course saying that further sharp lira depreciation jeopardises price stability. But core and headline consumer price inflation, currently in double-digits, demonstrates that monetary policy has been ineffective.  So, instead of making monetary policy more direct, the bank is aiming to use Turkish corporates to both contribute to forex market stability and to curb the adverse effects of lira weakness on pricing behaviour. 

By shifting future forex demand to lira demand in the case of further weakness (as obviously expected), the bank believes that it will be making a significant contribution to the exchange rate risk management of corporations without depleting the central bank’s forex reserves. However, they still remain highly exposed to interest rate risk, given that the current benchmark bond yield stands at 13.8 percent, and thus reflects potential cash-flow problems.

Balance of payments of Turkey, Sept. 2017 (source: CBRT)
Balance of payments of Turkey, Sept. 2017 (source: CBRT)

It makes perfect sense for the central bank to try to prevent industry (thus the Turkish economy in general) receiving a huge hit from expected forex fluctuations. Furthermore, it is no secret that each year, between December and February, Turkish corporates line up to repay their forex obligations, pressuring the lira and often triggering forex sale auctions by the central bank. Thus, the employment of “non-deliverable foreign exchange forward transactions” would be a worthwhile step in preventing speculative overshooting in the forex markets, which would in turn damage the whole economy. 

However, while welcoming the bank’s latter move, previously implemented by the Bank of Brazil during between 2010 and 2012, the Brazil case demonstrates that such currency interventions will be insufficient unless accompanied by a fully fledged monetary commitment against inflation.      

The move appears even less sufficient given the deterioration in other main macroeconomic indicators. After high double-digit inflation for October, September balance of payments data released this week underlines another important weakness in the Turkish economy.

The $4.5 billion September current account deficit for the month brings the 12-month rolling deficit to $39.3 billion, a whopping 4.6% of GDP.  There is no doubt that the widening deficit is the by-product of the government’s stimulus measures to keep economic growth intact during the referendum period earlier this year. It also reflects pressure from rising oil prices, which are expected to remain at current levels for the time being. The main fragility stems from the financing structure of the current account deficit. The September data points to a decline in direct investments and higher dependence on “hot money flows,” as seen in the net errors and omissions data set. 

So with regards to the Turkish economy, we have:

  • soaring GDP growth (thanks mostly to the base effect from last year) and high unemployment, which appears almost immune to strong GDP growth.
  • an inflation rate apparently sticky in double-digits, given the absence of a coherent monetary policy
  • and most troubling; the growing twin budget and current account deficits that keep the dark clouds hanging over the Turkish economy.

This brings us to the simple question of whether the central bank is capable of keeping the brewing economic storm at bay. Turkish lira volatility, the widening budget deficit; the gaping current account deficit, high inflation and an incompatible monetary policy all form the forces of gravity for further lira weakness down the road. As the base-year effect will soon become less favourable for economic growth data, the only thing that could save the Turkish economy from being a laggard among other emerging markets is policy change. Yet with the 2019 presidential elections the government’s sole obsession, it appears harder each day to find a way out.

Turkey's international investment position (source: CBRT)
Turkey's international investment position (source: CBRT)