Lira struggles for direction

By:
Solomon Teague
Published on:

Turkey has made progress in reducing its debts, while expectations for rate rises in the US have abated in recent months. But political upheaval in the country has led investors to run for cover, and a new and relatively unknown central bank governor faces a dilemma on interest rate policy.

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Turkey's central bank governor, Murat Cetinkaya speaks during a news conference in Istanbul

It was just the latest in a series of events that have held the Turkish lira hostage in recent weeks: an unexpected resignation, of Turkey's prime minister, Ahmet Davutoglu, earlier this month, after he had fallen out with Turkey's president, Recep Tayyip Erdogan, and another day of substantial volatility for the Turkish lira. 

On Thursday, Binali Yildirim, an Erdogan loyalist and transport minister, was picked as the next prime minister, with the lira broadly flat on the news. 

The appointment last month of a new central bank governor, Murat Cetinkaya, was a key development for investors. Cetinkaya was an internal promotion from within the Central Bank of Turkey and he was seen as a non-political appointment. On this occasion, a bout of volatility was avoided. 

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The market had been concerned about the identity of the incoming governor because it was assumed there would be considerable pressure on the central bank to reduce rates to stimulate the economy. 

It was important, the market felt, that an indisputably independent figure was named in the role, who would be strong enough to resist this pressure and make decisions for the longer-term economic health of the country, not for short-term political expediency. 

Whereas the resignation of the prime minister had undoubtedly spooked markets, with the lira weakening by around 4% against the US dollar in response to the news, the market took the announcement of the new governor in its stride. 

There has been some debate as to whether his early performance has vindicated this early optimism. In Cetinkaya's first monetary policy meeting the central bank lowered the overnight lending rate from 10.5% to 10%, continuing a cautious loosening trend, citing stable financial market conditions. 

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For some observers, who say this move was hard to justify, this fed concerns about Cetinkaya's independence. William Jackson, senior emerging markets economist at Capital Economics, says looser policy did not seem warranted, with inflation, at 7.5%, still above the upper band of the target range and inflation expectations near multi-year highs. The economy also looked strong enough to not need further stimulus, he adds. 

Others were more sympathetic. Nicholas Laser-Ebisch at Caxton FX says the move was justifiable given the slow start to 2016 by the Turkish economy. The move "matched expectations and signalled that [Cetinkaya] will not bow to government pressure and cut interest rates further straightaway unless it is deemed necessary," he says. 

The move does leave Turkey exposed to greater risk if the US surprises markets with an earlier than expected rate rise. Given Turkey's still elevated current account deficit, which totalled 4.5% of GDP last year, the country remains vulnerable to less-favourable external financing conditions, leaving the central bank with little choice but to follow suit with its own rises once the Federal Reserve makes its move. 

Some are concerned that future rate rises might end up being more aggressive than they need to be to get ahead of the US Fed, and that this might end up destabilizing Turkey further down the line. 

Cetinkaya therefore faces a dilemma over how to manage rates policy, making interest in his independence from the government all the more acute. The government will be keen to see further rate cuts, but this would likely create additional currency weakness, raising the costs of imports and potentially stoking an inflation crisis. Without a rate cut, however, growth might continue to decline and unemployment might rise further.

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This dilemma comes as the central bank wrestles with declining net foreign assets, which fell from $28.2 billion at the end of December to $25.5 billion on May 6  – although Cetinkaya did put a stop to the bank's strategy of daily US dollar sales in his first press conference as governor. 

Laser-Ebisch says: "Higher interest rates are necessary to keep assets in the country, as lowering interest rates would likely lead to further depreciation of the currency. Interest rates will likely be held where they are, as political risk has already been a big driver of Turkish lira weakness over the last few years, and cutting rates further would likely lead to more instability."

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Inside Turkey, political manoeuvring is heading towards a possible referendum, if Erdogan is able to make constitutional changes he has long sought to strengthen the power of his presidency. 

Further media speculation has also cast doubt on the position of deputy prime minister Mehmet Simsek, an influential pro-market figure, whose replacement would likely add to the pressure on the lira. 

Lee Hardman, currency analyst at MUFG, says: "Heightened political uncertainty is likely to result in a more volatile and weaker lira, reducing the scope for further monetary easing. It could provide the first real test for new governor Cetinkaya."

According to the Institute of International Finance, political upheaval last year dampened net private capital inflows into Turkey, from $49 billion in 2014 to $34 billion in 2015, "the lowest level of inflows since during the global financial crisis in 2009," notes Hardman. "The decline," he adds, "reflected primarily significantly lower lending by foreign private creditors as a well as a reversal in foreign portfolio investment inflows." 

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The impact is also being felt in the real economy, for example via tourism. According to a note by Citi: "Only in Britain the number of travel bookings to Turkey has fallen by 180,000 in the first 4 months of 2016, compared to the same period last year. Summer travel bookings to Turkey have fallen by 35-40% this year so far, according to international tourism package operators."

The fear will be that a continuation of the political uncertainty in the country will lead to Turkey continuing down the path it travelled for much of last year. Modest gains against the US dollar from earlier this year have now been fully reversed, leaving the Turkish lira as one of a small number of currencies that have failed to benefit from broad-based US dollar weakness, says Hardman. 

Hardman predicts that we could now be at the end of the recent consolidation phase for US dollar/Turkish lira, which has been trading roughly between the 2.8000 and 3.0500 levels since the summer of last year. "In light of recent political developments we are reassessing our outlook for modest lira weakness in the year ahead," he says. 

He adds: "We have incorporated a 5-10% political-risk premium to account for recent negative developments. However, we still believe that lira weakness should prove more modest than last year given the Fed’s more cautious outlook for tightening. Our year-end forecast for US dollar/Turkish lira has been raised to 3.1500. We believe that risks for the lira remain skewed to the downside."