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Turkish central bank woke up, now it’s the government’s turn

In a long overdue move, the Central Bank of Turkey (CBT) acted decisively on Thursday to stem losses for the lira that have fed Turkey’s consumer price inflation in an ongoing devaluation. 

A massive rate hike of 625 basis points brought the policy rate to 24 percent. This fifure compared with annual consumer price inflation of 18 percent, putting the central bank ahead of the curve, at least temporarily.

The central bank has finally woken up to the realities of the Turkish economy, explaining its decision by acknowledging the disturbing effects of inflation and how domestic demand is now being suppressed as the economy heads into a recession starting from the third quarter of the year.

It was just unfortunate that as the central bank grasped the economic realities and acted on them, President Recep Tayyip Erdoğan shrugged off the very same realities and instead blamed both the central bank and people outside of his economic management team for Turkey’s ailing macros-imbalances. The most important of these realities is the domino effect of high yields - the by-product of high inflation - and the weaking lira on heavily indebted Turkish corporates.

Then, Treasury and Finance Minister Albayrak, with a rather neutral tone, announced that the 625 basis-point rate hike should end the intense debate about central bank independence. He shifted attention to the government's upcoming three-year fiscal plan (Medium Term Plan – MTP) to be unveiled on September 20. 

The central banks’ rate hike boosted the crisis-hit lira from around 6.43 against the dollar to some 6.03 in the early hours of Friday. Global dollar weakness has also helped the lira gain ground over the past 24 hours. 

It now seems that the central bank has bought the Erdoğan-Albayrak duo very precious time to return to rational action on the fiscal front, I would expect the lira to remain stable at around current levels ahead of Albayrak’s announcement of the plan’s details.

Yet, the window of opportunity is rather limited. September-October inflation is set to march on towards 25 percent, rendering the current policy rate of 24 percent far less weighty.  Albayrak told local medai that inflation is due to peak in October and then start to ease.

Well, such a change of direction is of course possible if and only if the fiscal policies designed for the next three years stand fully compatible with the burning requirements of the Turkish economy. Corporate sector debt and the accompanying potential problems in the banking sector need to be addressed, along with fiscal measures that would profoundly shift state spending under a new visionary model.

To recall, the problems of hard currency-indebted corporates had intensified as the lira/dollar rate breached levels of just 4.5 per dollar. Now that the lira is 40 percent weaker still -- assuming that it will stabilise at around 6.0 -- the problems of real sector companies are still as tangible as they were a week ago.  Moreover, the central bank’s rate hike will cement already high interest rates in Turkey, increasing problems for cash-strapped companies.  

Turkey can now attract much-needed foreign funds back into the country by proving its rationality not only in economic management, but also in all other areas that have been deteriorating over the past five years or so. The details of the July balance of payments data, published on Friday, show that while the current account deficit is starting to ease (from $57.5 billion on a 12-month basis in June to $54.5 billion in July), the sources of financing have dried up, aside from unrecorded inflows in the form of central bank-defined net errors and omissions.  Such deterioration in the investment picture shows that despite the level of interest rates in Turkey, further mistakes in economic management will not be tolerated. The situation for the lira is, in effect, as fragile as it was before the 625 basis-point rate hike. There is no room for error.  

Changes to fiscal policy will be the first test of Turkey’s mettle following the central bank’s daring decision. In the absence of credible austerity on this front and the shifting of critical resources to value-added sectors that will enhance Turkey’s growth potential in a healthy manner, lira depreciation will soon re-emerge as the Fed moves on with rate hikes.      

To stem a full-blown financial fallout in the Turkish economy, the fiscal game plan is of paramount importance. Just as it should be credible, it should also address the most pressing debt problems of Turkish corporates and the damage those issues would otherwise inflict on Turkey’s banking sector. There should be a debt restructuring plan for those companies that are able to survive the current turmoil, while those who have become a lost cause should be set loose from being a drag on the economy as a whole. The plan needs to be a cleverly designed support scheme directed at both banks and remaining companies. 

The decision-makers are of course no other than Erdoğan, who will be electioneering until a March 2019 vote, and his son-in-law Albayrak, now in charge of the economy and toward whom market hopes have now been raised.  The duo will be sailing Turkey out from very troubled waters at home and through a very tough external environment internationally. To do that job successfully will require realism, transparency and of course fresh funds.