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Sep 13 2018

Turkey’s central bank hikes rates to 24 percent; lira jumps

Turkey’s central bank raised its benchmark interest rate by 625 basis points to 24 percent in a meeting on Thursday. The lira surged.

Investors had called for a big hike in rates to support the lira, which had lost 40 percent of its value this year. The average estimate in a Reuters survey was for an increase of 325 basis points.

The lira jumped, rising to as high as 6.01 per dollar. It added 2.5 percent to 6.18 against the U.S. currency at 5:25 p.m. in Istanbul.

The central bank had failed to increase its benchmark rate of 17.75 percent since Turkish President Recep Tayyip Erdoğan won a second term in office on June 24 even as the lira continued to tumble. Earlier on Thursday, Erdoğan said he opposed higher rates claiming they were inflationary and blamed the central bank for failing to reach its inflation goals.

In a statement, policymakers stressed that the decision was based on a general deterioration in the inflation outlook, which pointed to significant risks to price stability despite weaker domestic demand. Consumer price inflation climbed to 17.9 percent in August from just over 10 percent at the start of the year. Economists expect annual price increases to accelerate to almost 20 percent by December, according to a central bank survey.

“Tight stance in monetary policy will be maintained decisively until inflation outlook displays a significant improvement,” the central bank said. “If needed, further monetary tightening will be delivered.”

The main BIST-100 share index rose 1.2 percent to 93,288 points.

The central bank also said it would lend to banks solely via the benchmark one-week repo rate of 24 percent, ending a policy of providing funding to financial institutions via separate overnight lending.

Investor attention will now turn to Turkey's impending economic contraction and the government's economic program, set to be announced this month.

"Although this hike will not eliminate the myriad of challenges that Turkey’s economy and the markets face, it does eliminate some of the more adverse outcomes for Turkey’s economy.," said Inan Demir, an economist at Normura Holdings in London.

"In the absence of a bold move, the external debt rollover challenges for banks would likely worsen, the damage on corporate balance sheets could intensify and local deposit holders’ confidence would have weakened further," he said. 

Most economists are predicting negative economic growth starting from as early as the third quarter, in a sudden reversal in activity. The expansion slowed to an annual 5.2 percent in the second quarter from 7.3 percent in the first three months, with quarter-on-quarter growth narrowing to 0.9 percent from 1.5 percent. 

A likely recession, defined as two consecutive quarterly contractions in grwoth, will squeeze companies' profit margins and could lead to a sharp increase in non-performing loans and other borrowing difficulties, hurting banks' balance sheets. Indicators for consumer and business activity have already deteriorated sharply.

Brad Setser, a senior fellow at the Council on Foreign Relations, said banks could find the recessionary environment tough to handle.

"Negative interest margins for the next few months = no profits to offset inevitable losses on domestic lira and foreign exchange lending," Setser said. "Watching to see credible estimates of the scale of those losses. Expect some need for government recapitalisation." 

Analysts will also be looking to current account data for July, due to be published on Friday, to assess how the lira's decline is impacting a deficit that has reached 6.5 percent of gross domestic product. The current account could switch to a surplus as imports shrink and exports become cheaper on international markets, analysts at the Institute of International Finance say. However, Turkish exporters rely heavily on imports to finish their products, with imported goods constituting about 70 percent of exported products.

As the recession bites, tax revenue will also dip, meaning the government will need to tighten budgetary spending just when it is preparing to fight local elections. The polls are slated for March. Erdoğan, who rose to prominence as mayor of Istanbul in the 1990's, has already instructed his party to prepare for campaigning.

(Story was updated with economist's comment from the 10th paragraph).