Turkey’s central bank faces credibility test as market urges rate hikes
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Turkey’s central bank faces credibility test as market urges rate hikes

A weakening currency, strong credit growth and inflationary pressure will force the central bank to raise interest rates in the teeth of political pressure, imperiling the government’s growth target, analysts say.

The Turkish central bank is heading for a showdown with the government next week amid expectations it will hike interest rates to control inflation and shore up a weakening currency.

Erdem Basci, Turkey central bank governor

On Tuesday, the TCMB – headed by Erdem Basci – took the unusual step of signalling the Monetary Policy Committee (MPC) would consider widening the interest-rate corridor at its July 23 meeting, in a verbal intervention to boost the currency and attract foreign capital to cover the yawning current account. The account is under pressure from global bearishness toward emerging markets and the government’s lurch against the foreign “interest-rate lobby”.

In a push to bolster GDP growth, Mehmet Zafer Çaglayan, the minister of economy, asserted earlier this year how interest rates could continue to drop, partly to help boost growth to 4% this year, up from a miserable 2.2% in 2012.

Driven by increasing levels of consumption, low interest rates have led to a credit-fuelled boom, above the central bank's target. “The government is looking to keep interest rates low to rally support for the prime minister Recep Tayyip Erdogan’s Justice and Development Party before the upcoming elections,” says Mohammed Kazmi, analyst at RBS.

Turkey is set for local elections in March and presidential elections in August 2014, and parliamentary elections planned for 2015 could potentially be pulled forward from 2015 to 2014.

Indeed, Erdogan and Çaglayan have accused Turkey’s interest-rate lobby – apparently consisting of bankers and financiers – of pushing for interest-rate hikes to make easy money. The lobby, they argue, is the culprit behind the recent political turmoil which has overwhelmed Turkey in recent months.

“The central bank continues to portray themselves as an independent body but it is clear to see they have been traditionally aligned with the government’s position towards monetary easing,” says Kazmi.

Christian Keller, head of emerging EMEA research at Barclays Capital, adds: “When Erdogan and Çaglayan explicitly say higher interest rates are basically a conspiracy against the government, it naturally makes a central bank reluctant to raise interest rates.

“Political influence on central bank policy seems quite evident. As a result, the central bank is likely being more cautious regarding raising rates.”

The central bank can no longer rely on GDP growth figures to boost popularity, explains Kazmi, adding: “Voters are not only interested in economic growth, but also in the strength of the lira. Both factor as barometers of success of the economy and this can no longer be ignored by the government.”

Turkey’s central bank has spent more than $6 billion this year through foreign currency auctions, accounting for more than 10% of its net foreign reserves to prop up the currency, to little effect and the lira has remained close to record lows.

As it stands, the central bank has reserves of around $105 billion excluding gold, with $160 billion-worth of short-term debt due during the next 12 months. Add to this a current-account deficit moving towards the $60 billion mark and this means financing needs are roughly around $200 billion.

“The central bank has let overnight market rates go up to the upper end of the interest rate corridor [6.5%], but this is not enough,” says Keller. “I would expect that at the July 23 MPC meeting, they would need to raise this by 50 basis points, possibly 100bp.

“In the remainder of the year, they would probably need to raise interest rates by 150bp to 200bp to stabilize the currency and bring in fresh flows.”

Kazmi agrees that the pressure on interest rates is mounting. “By the next MPC meeting on July 23, we expect 100bp of hikes in the upper end of the interest rate corridor,” he says.

If the central bank does not hike rates, the worst-case scenario could be that the lira hits all-time lows of two lira to the dollar. “It would be all over the news that the economy is crashing,” says Kazmi. “The government couldn’t cope with something as drastic as this.”

Foreign direct investment

As Keller highlights, there is no way that Turkey can finance the current-account deficit by spending reserves. “What they need to do is get flows back,” he says. “Then the question simply becomes: ‘How much yield shall we offer?’”

Another option for Turkey would be to increase the amount of foreign direct investment (FDI) that flows to the country, to boost the quality and quantum of current-account cover.

During the past 18 months, the financing of the current-account deficit has almost entirely been kept up by portfolio inflows. However, while these flows are very much independent of the domestic political situation, they have suffered because of expectations of the tapering off of the Fed’s quantitative easing (QE) programme.

When the first tapering talks started in May, it would be fair to assume the initial withdrawal of capital flows was a short-term reaction to QE on emerging market rates but that there would soon be an adjustment and things would continue as normal.

“In a situation where the capital flow disruption was deemed a merely temporary phenomenon, it could be sensible not to mess around with interest rates and, instead, release some of your foreign currency reserves into the economy,” says Keller.

“But [the belief it was only a temporary disruption and things would go back to the ‘pre-tapper-talk’ situation] was a misjudgement, clear because the US curve has permanently shifted higher.”

As domestic political tensions continue to simmer under the surface, long-term investors will remain steadfastly risk-off when it comes to Turkey, say analysts.

Meanwhile, fears are growing that the country will fail to to attract FDI from the MENA region, thanks to its foreign policy, with Erdogan seen as critical of the intervention in Egypt that deposed the Muslim Brotherhood, while Middle Eastern neighbours Saudi Arabia, the United Arab Emirates (UAE) and Kuwait have pledged $12 billion in aid to Egypt since the ousting of Morsi.

In addition, the UAE has pledged to give Egypt a $1 billion donation as well as a $2 billion interest-free loan.

“This is going against the actual plans of Turkey, which aims to diversify away from its reliance on Europe and towards the Middle East and Northern Africa,” says Kazmi. “Erdogan’s rhetoric towards these countries could cause potential problems.”

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