A belated sense of realism appeared to be in evidence in Ankara this week when the Central Bank of Turkey (CBRT) raised its inflation forecasts to 12.1% for the end of this year and 9.4% for the end of 2021.
“Whether inflation falls below 10% next year clearly depends on the external backdrop, the global recovery and FX,” says Deutsche Bank emerging markets strategist Christian Wietoska. “But 9.4% is much more realistic than the CBRT’s previous forecast or our initial expectations of an increase in the forecast to 8%.”
9.4% is much more realistic than the CBRT’s previous forecast
Christian Wietoska, Deutsche Bank
However, the CBRT has some way to go to convince the market that it is serious about tackling inflation, reducing the banking sector’s reliance on external funding and resisting political interference.
Turkey has taken a variety of measures to prop up the lira this year. These include imposing withdrawal limits and time delays (mostly for private individuals owning FX deposit accounts) and increasing in size and frequency short-term and long-term FX swaps and gold swaps in order for the CBRT to source more USD that can be sold to support TRY.
In March, the bank insurance and transaction tax introduced in 2019 was increased from 0.2% to 1% for purchases of FX and gold.
Running down its FX reserves and freezing international banks out of its FX market provided short-term relief during June and July, but reduced these reserves to dangerously low levels.
Since August the lira has continued to depreciate against a backdrop of high inflation, large macro vulnerabilities and rising geopolitical tensions.
Turkey’s intention appears to have been to warn banks and investors that there could be regulatory issues for those aggressively shorting the lira. But such actions proved counterproductive.
Making it more difficult to trade and transact in lira hurt Turkish as well as foreign businesses and investors, and made foreign investors less willing to invest in Turkish markets.
It is never good for a central bank to have a negative net international reserve position
Tim Ash
“For example, the restrictions on offshore TRY liquidity made it harder for buyers of TRY/GBP to hedge their TRY exposure, so foreign demand for Turkish government debt reduced and this increased its borrowing costs,” observes BlueBay Asset Management economist Tim Ash.
Ash estimates that the net FX reserves of the CBRT have moved aggressively into negative territory by as much as $40 billion.
“It is never good for a central bank to have a negative net international reserve position,” he says.
The negative net reserves number means that the central bank and Turkey are on borrowed time – via coerced foreign exchange swaps with domestic banks as well as arrangements with the central banks of Qatar and China, notes Dennis Shen, director of sovereign and public sector at Scope Ratings.
“There is enough foreign currency in the system for now to keep transfers of resident-sector foreign currency to the government going,” he adds. “However, adopting such a model instead of hiking rates, curtailing elevated credit growth and reducing institutional deficits does not end well.”
Tense situation
As long as commercial banks are willing to lend to the CBRT it will have money to defend the lira. But Cristian Maggio, director and head of emerging markets strategy, rates and FX at TD Securities, warns the situation is getting more tense by the day and the risk of a run on bank deposits continues to grow.
His assessment of the options available to Turkey to minimize the political and economic damage that would result from further lira depreciation is much tighter rates – “anywhere between 200 basis points and 500bps should be enough if delivered rapidly” – and a swift change of course for the country’s macroeconomic policies.
Pressure from president Erdogan means the central bank will continue to tighten monetary policy
Liam Peach, Capital Economics
“The former is likely to be adopted – though not as rapidly as the market demands – as the only short-term solution to an ever-growing problem,” says Maggio. “The latter is very unlikely to change as the popularity of president [Recep Tayyip] Erdogan rests with his pro-growth policies.
“Therefore, an expansionary orientation of government and CBRT actions, even to the cost of high inflation, is likely to persist. This will continue to allow macro financial imbalances that are the root cause of lira weakness to persist.”
FX reserves are now so low that the central bank will need to tighten monetary conditions much more aggressively to prevent further sharp falls in the currency, says Liam Peach, emerging markets economist at Capital Economics.
“This is more of a political than an economic concern and pressure from president Erdogan means the central bank will continue to tighten monetary policy through the back door, which will ultimately lose the confidence of investors,” he adds.
According to Peach, Turkey’s banks are more vulnerable to a sell-off in the lira and a tightening of external financial conditions than they were in the run-up to the 2018 currency crisis, and until these vulnerabilities are addressed the lira will continue to depreciate.
Backdoor methods of monetary tightening… are not what markets seek
Dennis Shen, Scope Ratings
Ash suggests Turkey needs to adopt credible monetary policies, which means higher policy rates, to stop portfolio capital flight by foreigners and increased dollarization by locals.
“It needs to accept a period of lower real GDP growth, domestic demand and import demand to reduce the current account deficit and close the external financing gap,” he says.
“If Turkey does not want to impose capital controls to artificially reduce demand for FX, restructure FX liabilities or go to the IMF to secure additional FX resources to help fill financing gaps – and lacks the resources to fill the financing gap by FX reserves intervention – the lira has to go weaker.”
Additional lira depreciation would not only precipitate more open-market interventions to ease the speed of devaluation, but also lead to forced monetary tightening, says Shen.
“Backdoor methods of monetary tightening such as alterations within the interest rate corridor are not what markets seek,” he concludes. “A significant and credible hike sends the signal that the central bank will do what’s required to achieve price stability.
“Due to interference in central bank independence, the problem is that any further outright hikes in central bank rates are likely to come with political cost unless they are managed carefully.”
