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Mark Bentley
Sep 11 2018

Turkey between two fires ahead of critical rates decision

The Turkish authorities may be thinking long and hard about raising interest rates to stem a currency crisis after huge increases by Argentina failed to reverse a sell-off of the peso.

Turkey’s central bank is meeting in Ankara on Thursday, pledging to “re-shape” monetary policy after inflation surged to 17.9 percent and the lira tumbled. But economists are uncertain whether policymakers will increase the benchmark rate of 17.75 percent at all, and whether any monetary tightening will be enough to satisfy fraught investors.

Turkey finds itself between two fires. President Recep Tayyip Erdoğan and his central bankers have no doubt been watching events unfold in Argentina, which has raised its benchmark rate by 32.25 percentage points since late April to 60 percent, including a 15 basis-point hike on Aug. 31, only to see the peso slump to fresh record lows.

At the same time, Erdoğan, who is preparing to fight local elections in March, has garnered support among voters since presidential elections in June by blaming the West, led by the United States, for Turkey’s economic ills. The central bank has kept the benchmark rate on hold since the nationwide vote despite growing losses for the lira. While Erdoğan, who is seeking to avert a politically-damaging recession, might prefer the bank to keep the rate steady again, a hike that is too moderate, coupled with a likely tinkering of other interest-rate tools at the central bank’s disposal, also runs the risk of provoking another sell-off in the lira and even deeper economic troubles for the country.

The Turkish lira has lost some 40 percent against the dollar this year, eroding living standards and raising concerns for a full-blown economic meltdown. The currency is the second-worst performer in emerging markets after the Argentinian peso, which has lost more than half of its value this year. Currency crises in both countries are beginning to undermine financial stability in other developing nations, raising fears of a repeat of the Asian financial crisis of 1997, when contagion spread across emerging markets.

Th majority of foreign analysts are urging the central bank’s Monetary Policy Committee to raise rates by 500 basis points or more. Despite the negative impact of higher rates on the economy, which is already set to contract from the third quarter, they say Turkey risks a further currency spiral and more economic troubles should the central bank fail to tighten monetary policy substantially.

Still, analysts and investors have serious doubts about whether Turkish authorities are ready to take the pain, pointing to the central bank’s inaction on interest rates since the June polls.

“Although we strongly believe that this should be done, we do not have a high conviction that it will happen,” said Inan Demir, who works as an emerging market economist at Nomura Holdings in London. “Turkey’s political environment does not appear to be conducive to large, orthodox policy rate hikes as evidenced by the non-hike in the first MPC meeting after the June presidential elections.”

The central bank may raise the benchmark rate by 325 basis points to 21 percent, according to the median estimate in a Bloomberg survey of analysts. Two of the 22 analysts saw no change.

Turkish central bank governor Murat Cetinkaya
Turkish Central Bank Governor Murat Çetinkaya

Unlike the approach of investors to Turkey, the Argentinian central bank’s latest move to increase rates caused some consternation in financial markets, coming just a day after President Mauricio Macri said he was asking for the early release of funds under a $50 billion IMF programme. The sequence of events demonstrated hyperactivity verging on desperation, according to some analysts, and the peso, while steadier since, still remains close to record lows. Turkey’s behaviour, however, has been far from overzealous.

Ratings agencies have downgraded the country deeper into junk territory this year citing Erdogan’s increasing grip over the economy, the central bank’s reluctance to forestall market turbulence by hiking rates and a pile of unhedged foreign currency debt amassed by Turkish corporates since the 2008 financial crisis. The loans, totalling more than $220 billion, are becoming more expensive to repay as the lira falls, threatening a wave of bankruptcies in construction, energy and other industries. About $75 billion of corporate debt comes due in the next 12 months.

Since Erdoğan won re-election on June 24 with increased executive powers, the central bank has not raised its benchmark rate despite deepening losses for the lira. At the same time, Erdoğan has appointed his son-in-law Berat Albayrak to lead the newly merged Treasury and Finance Ministry. The president has also awarded himself sole power to appoint the central bank governor and his deputies, and reduced their terms in office to four years from five. Investors saw the move as further evidence that policymakers were losing their independence from politicians.

The sell-off in the lira deepened in August as Erdoğan became embroiled in an intensifying political spat with the United States over the detention of Americans on terrorism charges. Instead of backing down, he traded tit-for-tat economic sanctions with U.S. President Donald Trump from Aug. 1.

Rather than implementing a classic hike of the benchmark one-week repo rate, the central bank responded to the market turmoil brought on by the crisis with Washington by raising its average cost of funding by some 150 basis points to 19.25 percent through adjustments to other interest rates. Total losses for the currency during the month of August were about 25 percent.

Compounding investor concern has been the government’s failure to announce the details of an economic plan to lead the country out of crisis. Albayrak has said he will announce Turkey's so-called medium-term programme this month.

Unlike Argentina and its request for financial assistance from the IMF, Turkey says the economy is strong enough to withstand further turmoil alone, pointing to low sovereign debt-to-GDP ratios and a resilient banking sector, which survived the global financial crisis intact.

The economy stands firm in the face of Trump’s “brazen use of economic weapons” against the country, Albayrak said at the weekend, reiterating that the central bank was independent and ready to take necessary measures.

“In the face of all the negative propaganda, and the attacks on its financial system, the Turkish economy has demonstrated its strength,” he said in an op-ed for Foreign Policy magazine. “It is important to reiterate that no economic indicators or macroeconomic data can account for the devaluation of the Turkish lira over the past month. Turkey’s financial structure and banking system have not experienced any fundamental changes during this time.”

Turkish authorities may be misreading market sentiment after recent gains for the lira, said Tim Ash, a senior emerging markets strategist at Blue Bay Asset Management in London. The currency, which has rallied from a record low of 7.23 per dollar last month, rose almost 3 percent on Friday as some investors bet that policymakers would follow Argentina and hike rates in a big way.

Uncertainty has returned this week. The lira fell 0.7 percent against the dollar on Monday and was 0.1 percent stronger at 6.45 per dollar in midday trade on Tuesday.

“A message to the central bank -- Turkish assets are only rallying as they think you will do the right thing and raise rates on Sept. 13,” Ash said as the lira climbed on Friday. “Don't misread what is happening - if you screw up again and don't hike, you will be back in the same place at mid-August ... perhaps worse. Wake up and do the right thing.”