Twin bomb attacks on a busy Saturday night in the heart of the country’s largest city claimed the lives of 44 people; a suicide bomber rammed his car laden with explosives into a bus carrying off-duty soldiers, killing at least 14 of them; data showed that the country’s economy contracted for the first time in seven years; and a foreign diplomat was assassinated in the capital.

All these happened within a time span of just two weeks and in one place: Turkey. These were stark reminders of what investors see as the country’s toxic combination of economic, geopolitical and political risks that keep the currency under pressure and depress consumer and business sentiment.

The lira, which has lost nearly 20% of its value against the US dollar this year, could face further selling if the Federal Reserve continues to raise interest rates in 2017, probably triggering an exodus of capital from emerging markets.

Given this political and economic backdrop, most analysts were expecting Turkey’s central bank, which raised rates last month for the first time nearly in three years, to continue tightening rates to prop up the lira.

However, defying expectations, the central bank kept all policy rates unchanged this week, signalling that it is in a wait and see mode to measure the effects of the Federal Reserve’s policies, and other global development, such as oil prices, as well as domestic growth dynamics and the impact of the weakening lira on inflation. The bank left the one-week repo rate at 8%, the overnight lending rate at 8.5% and the overnight borrowing rate at 7.25%.

Economists believe as the lira comes under further pressure the central bank will be left with no other option but to raise rates in 2017, which is expected to be a turbulent and unpredictable year, with analysts predicting sharper volatility for the currency in the short term.

Moderate growth

The central bank acknowledged that exchange rate movements due to recently heightened global uncertainty and the increase in oil prices pose upside risks on the inflation outlook. But, it takes comfort from the fact that the aggregate demand developments restrain these adverse effects.

“Future monetary policy decisions will be conditional on the inflation outlook. Inflation expectations, pricing behaviour and other factors affecting inflation will be closely monitored and the cautious monetary policy stance will be maintained,” the bank said in a statement released after the monetary policy committee meeting on December 20.

Indeed, households’ final consumption fell by 3.2% in the third quarter from a year ago, after rising 3.7% in the previous quarter, and consumer confidence hit  a 14-month low in December.

But, the rate setters at the central bank are optimistic that economic activity will recover in the final quarter of 2016 and continue at a moderate pace.

The bank’s own survey showed last week that GDP growth forecasts for 2016 were slashed to 2.6% from 2.9% and estimates for next year were cut to 3.2% from a previous 3.3%.

Analysts at Commerzbank offer a rather damning outlook for the Turkish economy. “The framework conditions for the Turkish economy are extremely bad at present. The [recently published] GDP data only reflects this in part. In reality the situation is even worse and all known economic forecasts for 2017 are pure fiction. Nobody apart from the Turkish government would probably deny that the current situation in Turkey is anything but positive for the economy,” they said, noting collapsing visitor numbers and terror attacks.

Their GDP growth forecast for 2017 is at a paltry 1.7%, and even this is also under review. “That means the lira, which is already suffering from considerable depreciation pressure, is facing uncomfortable times.”

Opportunity missed

Nomura analysts think a modest hike this week probably would not reverse depreciation pressures, but it would have been an opportunity to acknowledge the deterioration in the inflation outlook and global backdrop and would be a signal to the market that last month's hike was not a one-off and that the TCMB is able to tighten, albeit in small steps.

“However, the central bank chose not to use this opportunity. The big picture remains that Turkey's external deficit is widening again despite weak economic activity, and policy rates did not adjust to compensate for the inflationary impact of currency weakness, which, all else equal, should add about 2 percentage points to headline inflation over the next 12 months.”

The risk-reward profile for TRY remains weak, according to the analysts who now see USD/TRY reaching the 3.65 level in three months' time rather than their previous forecast of 12 months.

JPMorgan and Goldman Sachs believe the central bank will tolerate a weak lira and will be reactive rather than proactive, observing first the currency’s performance. But, they are too of the view that the central bank will eventually hike.

“Policy decision - to keep rates unchanged - leaves the lira vulnerable to further depreciation pressures, and increases the chances that the CBRT would have to take stronger measures in the future to stabilize the currency, inflation and inflation expectations at some point in the coming months,” analysts at JPMorgan wrote in a research note.

They think the performance of the lira will be the main determinant of the timing and the magnitude of the next CBRT move. “The CBRT will in our view likely remain on hold unless the lira depreciates in a disorderly way.”

Goldman Sachs forecasts the TRY at 3.60 in 12 months and three hikes by the Fed next year, “leading to 200bps of hikes by the central bank of Turkey to keep inflation in check”.

As far as growth dynamics are concerned, the Goldman Sachs analysts think most support for the economy will be delivered fiscally and the central bank is likely to keep the financial conditions as loose as it can “even if this means a weaker TRY and a temporarily higher inflation rate as long as this adjustment is orderly”.

The unpromising economic and inflation outlook puts Turkey’s central bankers in a tight spot.

President Recep Tayyip Erdogan, who once described himself as “the enemy of interest rates”, has been calling for cheaper credit to boost economic activity. It remains to be seen whether politicians will increase pressure on the central bank to cut rates in the run-up to the referendum on the presidential system that is expected to be held by the summer of 2017.

The ruling AKP owes much of its past election victories to strong economic growth, thus it does not want to go to the popular vote on the presidential rule when the economy is weak.

According to analysts at Capital Economics, the central bank’s decision is only likely to be a pause in the tightening cycle and they expect substantial interest rate hikes next year. The recent stabilisation of the lira against the dollar, and comments from President Erdogan arguing against higher interest rates, probably played a role too, they think.

“We expect the tightening cycle to resume next year. For one thing, the economy should return to positive growth as the impact from July’s coup attempt fades. More importantly, the lira is likely to come under renewed pressure next year as the US Fed raises interest rates. Against that backdrop, we have pencilled in 150bp of hikes in the overnight lending rate, to 10.00%, by the end of next year.”

The lira, indeed, has stabilised this week in thin volume before the long holiday in many markets, trading at 3.5115 per dollar on December 21 versus 3.5327 a week ago.