Turkish contraction looms as rates fallout becomes evident

The Turkish government has once again used Interest rate hikes, late and high in magnitude, as a cure for imbalances in the economy that have been worsening since 2012. But this time its unfortunate remedy may result in an economic recession.

Just as the risks of investing in Turkish assets had seemed to reach critical levels recently, the Central Bank of Turkey’s 125 basis-point rate hike on June 7 was welcomed by investors. The central bank's move was interpreted as a sign that it is finally getting serious about Turkey’s very high inflation rate, rather than moving shyly to shore up the lira’s slide. After all, Turkey’s CPI inflation, which stood at around 10 percent at the start of the year, has reached 12.2 percent as of May and is set to accelerate in the months ahead.

From late April until June 7, the central bank’s rate increases added 500 basis points to the main policy rate, which is now up to 17.75 percent. In an urgent move two weeks ago, the bank also “simplified” its policy mix, fixing the one-week repo rate as the policy benchmark once again.

Nonetheless, since the start of the year, as the lira began collapsing on the back of sticky double-digit inflation, a high current account deficit and more risk aversion in global financial markets, the central bank’s inexplicable inaction has caused much damage to Turkey’s post-election economy. Now, with the fire in the currency markets extinguished, at least for the time being, it is time to make an assessment about the extent of the damage.

Firstly, the central bank’s much-debated credibility over the course of the past few years remains in doubt. President Recep Tayyip Erdoğan’s push for very strong economic growth amid ample global liquidity had been accompanied by serious mistakes in economic management. The central bank’s monetary policy was little more than complementary to the president’s methods and goals. Then, the loss in control of inflation and the turning of the tide in global markets manifested in a lira crash, which gained pace in the past three months, forcing the ruling Justice and Development Party (AKP) to switch mindset and behave according to internationally-accepted policy rules. 

Thus, it should be clarified that it was not Central Bank Governor Murat Çetinkaya taking control of monetary policy that saved the day, but rather Turkey’s long-necessitated rate hikes were policy decisions made at the very top of government. Çetinkaya and his deputies were then freed to act accordingly. Grasping this unfortunate reality gives meaning to why the risk premium for Turkey is so elevated, why the lira’s bounce has been limited and why a good chunk of investors remain sceptical about post-election economic management, should Erdoğan win the June 24 elections and introduce a full presidential system of government with all the increased control that brings.    

On inflation, there is no need to say that years of loose monetary policy have hurt expectations. The shock to the lira and of course higher oil prices have now elevated CPI inflation expectations to 15 percent at the start of the third quarter. The fact that the damage to the lira is here to stay is evident from its current level of about 4.5 per dollar, even after 500 basis points of rate hikes. And now sadly, one can’t expect year-end CPI inflation to slow to below 13 percent.

The policy rate of 17.75 percent and benchmark bond yields of 18.4 percent now set a new, higher plateau for interest rates in Turkey. Firstly, interest rates on deposits will increase, which will of course trigger a rise in rates on loans. Such a high central bank funding cost comes on top of banks’ rising costs of foreign borrowing with lower rollover ratios. This will directly translate into bank lending rates for corporates of between 25 percent and 28 percent.

Then comes the recession…

It would not be unrealistic to expect Turkey’s GDP to contract in the third quarter. The election outcome would hardly change such a growth outlook in the very short-term, regardless of whether AKP and Erdoğan win with increased powers for the president, or if the presidency and parliament are shared between Erdoğan and the opposition, forcing possible compromises in policy. Looking into 2019, a recessionary environment appears on the cards, if not stagflation.

The lira shock and very high lending rates have serious and repeated repercussions for Turkey’s fiscal accounts and the corporate sector.

As the economy slides into recession amid the higher rates, unemployment will pick up rapidly, the rise in wages and disposable income will fade and corporates will be pressured with heavy debts. We already know that many larger firms are lining up to negotiate with banks to restructure their debt obligations. Such restructuring will now become widespread throughout the business world. This will translate into higher lending rates, further squeezing firms who are trying to survive in a very difficult “high interest-high inflation-lower growth” environment.

Last but not least comes the burden of interest rates on the fiscal accounts. While the cost of Treasury borrowing will be the least of Turkey’s concerns, the economic slowdown, lower tax collection and perhaps a new round of amnesties on taxes will all widen the budget deficit to GDP ratio. Another aspect of the exchange rate shock on the fiscal accounts will be the pressure that it will put on municipalities that have accumulated large foreign exchange debts over the past decade. The pressures will be felt most when Turkey has local elections in 2019.

To sum up, Turkey’s newfound fragile short-term macroeconomic “stability” is based on higher interest rates. And there are no tangible signs yet that fiscal policy will aid monetary policy in the coming months. 

The “currency shock” and now the “interest rate shock” will keep shaking the foundations of the economy. The currency shock resulted in a spike in inflation and put very significant pressure on Turkish corporates burdened by heavy external debt. Now the interest rate shock will pressure lira-earning households, all of the real economy that is based on lira transactions and especially Turkish corporates. To escape from such strong double shocks would require a brand new, sound, credible macroeconomic perspective and a strong program of reform immediately after the June 24 election. And there is no need to say that some bold steps are needed to deal effectively with the foreign debt obligations of Turkish corporates in particular, which total about $226 billion.