Lira in the eye of the storm

Turkey has the ingredients for a falling currency, a dish Turkish savers know all too well, having lived through many cycles at the sensitive end of the EM currency spectrum.

Many have taken steps to hedge their losses, switching swaths of lira-denominated holdings into US dollars at the earliest signs of trouble for the domestic currency.

“Turkey has a rich history of financial crises and it is normal for Turkish households to switch their money into dollars when they are worried about the currency,” says Emre Akcakmak, portfolio manager at East Capital. 

“They will also switch it back when they feel the lira is cheap. It doesn’t usually determine the direction of currency moves, but it can make moves more dramatic. It can also smooth currency moves too – if people feel the lira has overshot on the downside, they will sell their dollars.”

This is likely to get worse before it gets better, with deteriorating conditions pushing a greater number of lira-denominated savings to be switched into dollars to preserve value.

Discreet challenge

Despite being one of its more discreet challenges, the principal force exerting downward pressure on the lira is the ascendant greenback. The lira has depreciated 10.5% against the dollar since July and while it is still a little off the 2.39 low against the dollar in January, Myers believes it looks set to get back to that level by the end of the year.

Turkey’s current-account deficit hit 7.9% of GDP last year, with the IMF expecting only modest improvement this year at 5.8%, and 5.5% to 6% over the next five years, given its energy-importing needs.

“Earlier in the year we saw the lira strengthen, despite its domestic weaknesses and political uncertainty, but now it is weakening and this is 80% to 90% driven by external factors, namely dollar strengthening and the expectation of rising US rates,” says Adam Myers, European head of FX strategy at Crédit Agricole CIB.

“As the cost of funding for the US dollar rises, the problems associated with the Turkish economy will be laid bare,” among them stubbornly high inflation and a current-account deficit that is larger, as a share of GDP, than any other major economy.

“Whatever plans Turkey outlines for reforming its economy, it is hard to see it being enough to prevent further deterioration against the dollar,” continues Myers. “Foreigners may continue to invest in Turkey, but most are likely to hedge those positions so it is won’t make much of a difference to lira levels.”

It is easy to miss the positive signs amid the gloom. The current-account deficit has improved somewhat, while lower oil prices should also benefit Turkey. Inflation has been a millstone around the economy’s neck, but looks at least to have peaked, with headline CPI easing in September to 8.86% year-on-year from 9.54% year-on-year in August.

Inflationary pressures have moderated across the board, with food, energy and core inflation creeping down. At the same time, the lira was weakening, at the start of September falling against the dollar to 2.28 from 2.15.

The Central Bank of the Republic of Turkey (CBRT) responded by pushing the repurchase rate higher to 8.50% to 8.70%. However, UBS does not expect any further change to monetary policy, believing the CBRT will miss its inflation goal of 5% plus or minus 2% regardless.

In the meantime, the high-beta lira looks set to make further falls, along with other EMs, as the date of expected US rate rises gets closer – but exactly how bad things will get from here for the lira is the subject of much debate.

Much depends on a number of variables, such as how the crisis in the Middle East develops. “Iraq was Turkey’s second-largest export destination in 2013 and had grown by 12% in the first five months of this year,” says East Capital’s Akcakmak.

However, the tensions hit exports by 31% year-on-year during the three months of June-to-August period, and exports to Iraq declined by 5% year to date.

“The Middle East in general and Iraq in specific are important markets for Turkey, as Middle Eastern exports account for a quarter of total Turkish exports,” says Akcakmak. 

Myers believes lira falls have much further to go, adding: “In the last two months, we have seen the lira outperform the NZ dollar and this is because it is easier for investors to sell their more-liquid Kiwi positions.”

In the three years to 2013, the lira accounted for, on average, around 1.3% of daily trading volumes, according to the Bank for International Settlements. The Mexican peso, by comparison, accounted for around 2.5% of average daily trading volume.

“For the remainder of the year, I expect to see the lira under performing [versus the Kiwi] because by now the more-liquid positions will have been sold and investors will have to work down the liquidity spectrum to middling-liquidity currencies like the lira,” says Myers.

“We are cautious on TRY and look for a faster depreciation against USD than the forwards, particularly over a six-month horizon,” says Durukal Gun, FX strategist at Barclays. “Our expectation for TRY depreciation against USD is consistent with the beta-implied move in USD/TRY based on our EUR/USD forecast.”

Possible actions by the rating agencies will also drive currency sentiment.

“If government pressure on monetary policy intensifies and geopolitical risks resurface, the risk of a negative rating action will increase and put further pressure on TRY,” says Gun.

However, the bearishness might abate in 2015. Gun adds: “The lira should benefit at a later stage from ECB balance-sheet expansion, which would ease the pace of depreciation.”

Akcakmak, however, believes the lira might prove more stable in the near term at least – providing there is no further deterioration in the geopolitical situation playing out on Turkey’s doorstep.

“In the short term, most market negativity looks priced in after the lira falls in August and September,” he says. “While I don’t expect the lira to fall much further than this, it would also not be surprising to see some more volatility if regional politics continue to develop in the wrong direction.”

Whatever happens, it will likely be all too familiar for Turks, who have lived through crises both political and economic, inside and outside their borders, which have periodically savaged their currency and their economy.

“The lira has gone through similar cycles for years,” says Akcakmak. “It is inevitable for an economy with a high current-account deficit like Turkey’s. The expectation for US rate hikes means Turkey is now on another downtrend. In the longer term, the lira will continue to depreciate. It is a structural necessity because of its high current-account deficit.”