Turkey’s not-so-independent central bank under pressure to hike rates

Few now doubt the Central Bank of the Republic of Turkey (CBRT) is on the verge of going against the wishes of president Recep Tayyip Erdogan and putting up interest rates from the current level of 8%.

The recent ferocity of the lira’s fall and the fact it is losing its grip on inflation – which now stands at 8.5%, up from 7% in November – mean it has little choice.

Turkey’s woes are principally of a political nature, so while the numbers do not make for comfortable reading, looking at charts does not tell the full story. Investors’ concerns spiked in the months after the failed coup attempt in July, as the full scale of the president’s authoritarian response became clear. 

Having said that, the numbers do matter.

Petr Krpata, chief EMEA FX and IR strategist at ING, says the lira has found itself in a vicious circle, where the weakening currency is undermining the inflation outlook, which in turn adds to the pressure on the currency.

“In the absence of capital controls, a large emergency rate hike seems to be the only remedy,” he says. “If the root cause is domestic, the solution must be domestic too.”

Krpata argues that a large emergency rate hike – either a standalone 300 basis point to 350bp increase in the upper band or a 200bp symmetrical increase in the policy corridor – would substantially turn around lira fortunes.

Such a move would not be unprecedented. Turkey was in a similar situation at the start of 2014, when the lira was falling and the CBRT was resisting market pressure to hike rates. It finally relented, increasing its one-week repo rate by 550bp, from 4.5% to 10%, in an emergency meeting – a move that reversed the fortunes of the currency, without quite restoring the value to its former level.

Emre Akcakmak, portfolio adviser at East Capital in Dubai, says: “We could see a similar move this time around. After all, the longer the CBRT waits, the bigger its eventual move may need to be to get inflation under control as the potential damage from currency pass-through grows and the confidence is hurt.”

If it opted for such a move, “the scale of the TRY rally would be around 10%”, predicts ING’s Krpata. However, he says, such a decisive move looks unlikely, with a more incremental approach likely to be favoured.

“Such an approach is unlikely to halt the TRY’s slide in the immediate future,” with the USD/TRY 3.90 level likely being tested, he says.

The CBRT dropped a hint this week that it was gravitating towards such a gradual approach. 

On Tuesday it reduced banks’ borrowing limits in the interbank money market to TL22 billion, effective from that Wednesday, while FX reserve requirement ratios were reduced by 50bp for all maturity brackets. Additional liquidity of approximately $1.5 billion was provided to the financial system, with a promise of more steps “if deemed necessary”.

This is in line with the CBRT’s preferred strategy for managing its currency. Although the CBRT did hike rates by 50bp in November, Selim Yazici, CEO of TEB Asset Management in Istanbul, says: “Instead of tightening monetary policy directly, the CBRT prefers to take measures to tighten lira liquidity conditions while simultaneously easing foreign-exchange liquidity conditions.”

However, the measures did not reverse the currency’s fortunes, and arguably exacerbates the problem.

East Capital’s Akcakmak says: “These small steps from the central bank only encourage speculation and are unfortunately not helping to improve the situation.” 

The Turkish lira has been under consistent pressure for several years now, having fallen against the dollar by 20% and 16% in 2015 and 2016, respectively. It is down around 9% already in 2017, with lira selling increasing in late September, once the market digested Erdogan’s response to the failed coup attempt.

Things got even worse when Moody’s published research suggesting deteriorating inflation was likely to undermine the profitability of Turkish banks.

Moody’s wrote: “Overall, given the challenging operating environment exacerbated by security issues, a significantly depreciated lira and the potential for further monetary tightening in the wake of higher inflation, we expect negative pressures on asset quality to intensify in 2017.”

The CBRT must now be coming to terms with the fact its recent attempts to stabilize the currency have failed and is likely to be considering its options, but these look limited.

Akcakmak says: “Never say never, but I don’t think capital controls have ever been on the table as a realistic option. Currency intervention is a possibility, but it is not a solution to the problems of inflation, Turkey’s external financing needs and heightened risk perception.”

TEB’s Yazici points out that the country also has less ammunition to protect the lira in the market. “Turkey’s foreign-exchange reserves remain relatively low compared to those of other emerging markets (EM), despite the annual increase in 2016,” he says.

At the end of 2016, Turkey’s ratio of FX reserves to GDP stood at 11.5% – the third lowest in the comparable EM universe.

Wolfgang Ernst, financial analyst at Raiffeisen in Vienna, says: “Whereas this decline in FX reserves is mainly due to the introduction of liquidity boosting measures with the reduction of reserve requirements of commercial lenders with the regulator, the comparably low level of gross foreign-exchange reserves ($92 billion) compared to its short-term debt could bear additional risk to TRY stability going forward.”

It is, therefore, left with two realistic options, says Andreas König, head of currencies at Pioneer Investments.

“The CBRT has to act,” he says. “It can either surprise the market with a huge hike or it can move in small steps. Its action on Tuesday suggests it will be the latter, but I expect it will have to act before its next meeting on January 24.”

As far as König is concerned, that means the Turkish lira story is finished from a risk/reward perspective, offering no more attractive investment opportunities.

“From here it is not an investment theme, but pure gambling over what the central bank is going to do,” he says.

Pioneer had four lira positions, two each against the dollar and euro, splitting the trade up to reduce the influence of EUR/USD moves. It has closed three of them, with only the EUR/TRY position remaining, which it has now hedged.

The problem is that, even if the CBRT does act decisively in raising rates, it has already suffered a considerable knock to its credibility, with few entertaining the notion that it is truly independent.

Krpata says: “TRY appears to offer value, but it is the CBRT that holds the key to unlocking it.”