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Guldem Atabay
Jan 17 2019

Turkish central bank helps credibility by keeping rates steady

Day after day, incoming macro-economic figures on Turkey are reflecting just how gloomy the economic picture is.

Industrial production data for November, published last week, showed a contraction in output of 6.5 percent year-on-year. The numbers demonstrated vividly just how sharp the GDP contraction is, despite the government’s efforts to boost demand through consumption tax cuts, which it has now extended into 2019. 

At first glance, budget data for last year, released earlier this week, appeared satisfactory, seeing as the government met its year-end deficit estimate, which was revised upwards in September.  Yet, a 70 percent annual contraction in sales tax revenues for December, along with a 20 percent spike in interest costs, likely provides a precursor to what is in store for 2019. Reducing the budget deficit to GDP ratio of 1.9 percent in 2018 to 1.8 percent this year, as the government envisages, looks like a challenging task indeed.

The government is busy trying to stimulate the economy through tax cuts and cheap loans via state-run banks, to the extent that it has even rescued football clubs. This is happening ahead of March 31 local elections, where the ruling Justice and Development Party (AKP) is expected to lose public support. The central bank, however, appears to be standing firm, resisting populist moves of its own.

In its Monetary Policy Committee (MPC) meeting on Wednesday, the bank kept its benchmark one-week repo lending rate unchanged at 24 percent. It said that despite some improvement in the inflation outlook, risks to price stability persist.  The decision was widely anticipated, so it was no surprise that investors’ focus would turn to the wording of the bank’s accompanying statement, which changed little from its previous meeting, when it also kept rates steady and maintained a tightening bias.

In the first half of last year, when Turkey was marching towards the June 24 presidential elections, President Recep Tayyip Erdoğan was not shy about pressuring the central bank to cut rates.  He famously based his argument on high interest rates being the reason for higher inflation. He repeated this false assertion on Bloomberg TV in May. It turned out to be very costly for the Turkish economy indeed. The lira plunged into a never-ending freefall, Turkey lost control of inflation through the currency crisis and, come September, consumer price inflation (CPI) was at almost 25 percent and producers price inflation was at a head-spinning 46 percent. The president’s theory was easily proven wrong as the spike in inflation was followed by a 625 basis-point hike in the central bank’s benchmark rate as policymakers reverted back to monetary orthodoxy. The rate of price increases has consequently slowed.

Turkey is again marching into elections, this time with the economy contracting severely. Last year’s currency crisis is taking its toll on every part of the economy. The president has stopped pressuring the central bank for a rate cut; an absenteeism that many Turkish citizens are not accustomed to. 

Erdoğan has not referred in any meaningful manner to central bank policy in some six months. This has given the bank the room to act according to the necessities of the Turkish economy.  Thus, Wednesday’s no-rate-cut move may have bolstered its credibility, which had melted away last year as it dithered amid all the political pressure.  Treasury and Finance Minister Berat Albayrak’s rhetoric supporting central bank independence also seems to have helped. The president’s son-in-law is climbing the learning curve of economics since his appointment as the new czar of the Turkish economy in July.   

Wednesday’s mini rally in the lira – the currency had gained more than 1 percent against the dollar at the time of writing -- is important because it demonstrated that the market has started to believe in Turkey’s central bank following its dismal policymaking over the past couple of years.  The turmoil that the economy endured last summer and its high political cost ahead of the local elections might also have taught the government a few lessons.  

In these circumstances, with the next central bank policy meeting due on March 6, the chances of a premature rate cut ahead of the local elections on March 31 have declined significantly.  That would surely help the lira’s performance, especially at a time when the U.S Federal Reserve is set to delay further rate hikes.  Such lira stability, and perhaps gains, could also help lower inflation expectations, which have turned sticky since the government-central bank duo favored growth over price stability.

That being said, inflation is by no means defeated. The government is targeting consumer price inflation of 16 percent for the end of the year and the rate is likely to remain elevated in a range between 16 percent and 18 percent throughout 2019.

Moreover, Turkey also has an unresolved corporate debt problem, despite concerted efforts by banks to help companies restructure borrowing. The deteriorating quality of the budget has also been a problem brewing for some time and it will become more tangible as each day passes.  Still, on the positive side, Turkey’s huge current account deficit, which peaked at 6.5 percent of GDP last summer, will shrink to negligible levels by the summer. The decline is hardly something to celebrate though, as the cause is obvious: severe economic contraction. 

The post-election period in Turkey will be a critical one in considering how to address Turkey’s funding requirements, which could be substantial if a speedy economic recovery is to be ensured. A decision by the government to agree or not agree to money from the International Monetary Fund will likely dictate the rate of economic growth for many years to come.