Watch out for the Turkish lira
It may have appeared strange to some to write early last week about how the Turkish lira was set to suffer in the coming months when it was on a very mild appreciation trend. But then came jaw-dropping September inflation data which showed Turkey’s consumer price inflation (CPI) at an annual 25 percent and producer prices (PPI) at 46 percent.
As if that bad news was not enough, the dollar also gained fresh momentum on the back of macroeconomic data demonstrating the strength of the U.S. economy. Ten-year U.S. bond yields headed to 3.23 percent levels.
So, first thing’s first. Let’s begin with the possible impact of the rate of inflation in Turkey on the lira.
It is obvious to any economist that cost pressures built on the PPI side (46 percent, y/y) are set to build on the CPI side (24.5 percent, y/y) in the coming six to eight-month period. Core inflation of 24 percent already proves that inflation is out of control for monetary policy makers due to mistakes over the past couple of years.
The central bank insisting on unorthodoxy when the global environment was slowly “normalising” amid signals of Fed rate hikes as far back as mid-2013 and the consequential hikes, which began in late 2015, should have prompted it to instead enact micro-prudential measures designed to combat soaring foreign exchange inflows into emerging markets.
Starting from mid-2016, the central bank should have evolved its monetary policy towards orthodoxy, simplifying its multi-layered interest rate policy and switching back to a single rate with an eye on inflation dynamics. During this period, it was obvious that the lira was set to weaken at least gradually along with other emerging market currencies.
Such a prudent approach would have slowed Turkey’s GDP growth rates but eased macro imbalances headed by Turkey’s huge external deficit. Fast forwarding to 2018, the lira would have still depreciated because the tide for emerging markets was turning markedly, but the pace of devaluation would not have accelerated to become a so-called “currency crisis” in Turkey’s case.
Of course, President Recep Tayyip Erdogan’s meddling in monetary policy at an ever-increasing pace since 2013 has a lot to do with the policy mistakes that the central bank is now blamed for. But the bank was crippled with political intervention, if truth be told.
The current inflation dynamics mean long-lost control for “inflation targeting”, which of course has roots in failed expectations management. Thus, it looks like the Turkish economy will be locked into high inflation for years to come. Adding to the problem for Turkey is the likely GDP contraction in 2019. Manufacturers now have no other option than to reflect mounting costs caused by the lira’s 40 percent depreciation in 2018 onto their end-products just to survive. Output is declining, margins are being squeezed and credit lines provided by banks are either full or lenders are not willing to increase them. Heavy debt repayments for Turkish corporates mean bankruptcy for many is just around the corner.
To prevent such lost years for the battle against inflation and for sustainable economic growth, the government is not really tuned in in terms of fiscal policy. Promises of savings of roughly $12 billion dollars in 2019 hardly look achievable as the economy is contracting, meaning lower revenues, and local elections are due in the first quarter. Moreover, even if a sizable saving from the fiscal accounts were achieved, the required vision to re-direct funds from the construction sector to more productive industries is hardly there.
In the short-term, the focus will be on the central bank’s Oct. 25 meeting.
Setting aside U.S. pastor Andrew Brunson’s possible release from house arrest in Izmir at an Oct. 12 court hearing, the market is now looking for further rate hikes from the central bank. In their last meeting, policymakers raised the main interest rate to 24 percent from 17.75 percent. But surging inflation in September now means that the bank is behind the inflation curve and not leading it. Failure to embrace the truth on the policy side and instead managing the Turkish economy with what could be termed “wishful thinking” means Erdogan and his son-in-law, Turkish Treasury and Finance Minister Berat Albayrak, are failing to see that there is an increasing possibility that by mid-2019 Turkey’s CPI inflation could reach a stunning 40-45 percent.
Coming back to external developments, further misery awaits Turkey because of the ongoing emerging market crash, the prospect of more Fed rate hikes and the likelihood that U.S. bond yields will surge faster and to a higher level. Rising oil prices (Turkey imports nearly all the energy it consumes), Italy’s worsening fiscal situation and the European Central Bank (ECB) stepping in during the months ahead add to the bleak picture.
To recall, the pain for emerging markets began in February when the U.S. dollar started to strengthen. The reason was of course falling risk appetite and the declining carry trade in which investors borrow where interest rates are low (mainly from the U.S. market) to invest where they are high (mainly emerging markets). These factors are now reversing a rally that occurred during 2016 and 2017. The strong U.S. dollar, along with higher rates and Trump’s tax cuts, has combined to suck in cash from emerging market assets. The Fed is describing the U.S. economic outlook as “remarkably positive” adding that the expansion could “continue for quite some time”. This translates into an equal weakening for emerging markets.
Turkey, an emerging market economy, is no different from any other and will prove to be no different in the year ahead.
So is there room for the Turkish lira to gain ground or at least hold its current position, given that it has already depreciated way beyond the value of other EM currencies, as the above chart suggests?
The facts are that the global environment will be further EM un-friendly, Turkey’s inflation will accelerate significantly, the central bank has only limited control over price rises at this point, the government is slow and insufficiently motivated to deal with the main problem in the Turkish economy -- corporate sector debt and its near future dangerous impact on the banking sector -- and it has no economic/political/social anchor left to hold on to other than Erdogan as EM assets continue to lose value in the period ahead.
There’s no doubt that such a concoction spells trouble for the lira. Following the pace of its 2018 devaluation, the currency could remain range bound for a couple of months at around 6.0-6.5 per dollar.
Yet watch out for a new bout of depreciation in the first half of 2019, with the trigger most likely to come from a piece of economic data or bad news from the banking sector.