Bernard Kennedy in Ankara -

The Turkish central bank cut its key overnight borrowing rate by half a point to 16.75% on October 16, but withstood pressure from industrialists and exporters for a sharper reduction.

The government bond market had largely priced in the rate cut in the wake of last month's ice-breaking 25-basis-point reduction and benign inflation data. Yields on the new benchmark 22-month discount bond were little changed at 16.3% in very early trading following the cut.

Elsewhere, disappointment reigned. Oguz Satıcı, president of the Turkish Exporters Assembly (TIM), accused the bank of "doping Turkey with hot money." The Assembly was one of a panoply of businessmen's clubs, employers' and exporters' organisations, sectoral bodies and trades union confederations who had published a full-page advertisement in national newspapers calling for a "shock" rate reduction. At least one leading figure in the ruling Justice and Development Party (AKP) had expressed similar views ahead of the decision-making Monetary Policy Committee (MPC) meeting.

Strong lira policy

Entrepreneurs are convinced that the central bank is following a "high interest-strong lira policy," offering high returns to foreign financial investors for the sake of short-term exchange rate and price stability - but ignoring the effects of high interest rates and the strong currency on companies and the trade deficit. When fears of global monetary tightening temporarily knocked the lira off course and helped to lift prices in the second quarter of 2006, the bank responded with two successive rate rises totalling 425 basis points. "Where else in the world do you have 10% real interest rates? Who wouldn't complain?" asks Tugrul Belli, advisor to the board of Turkish Bank, which has been a leading proponent of lower interest rates.

By September, the lira had hit an all-time high in real terms. Amid expectations of further cutting by the US Federal Reserve, the currency last week touched 1.18 to the US dollar - its strongest level since the crisis of 2001 - and a 17-month high of 1.66 to the euro. These rates have softened since on concerns about the possibility of Turkish military action against Kurdish nationalist PKK guerillas in northern Iraq and the upcoming US House vote on a pro-Armenian resolution.

Domestic demand cooled significantly after last year's rate rises, especially in credit-dependent sectors like property and automotives. GDP growth, which averaged 7.5% from 2002 to 2006, slowed to 3.9% in the second quarter. Economists believe the drop in demand has run its course, but most business leaders are unconvinced. At the same time, the current account deficit for this year is set to match the $33bn (8% of GDP) recorded in 2006. According to foreign trade minister Kursad Tuzmen, every 10% increase in the value of the lira adds 5% to the import bill - and helps put local companies out of business.

Fiscal alert

The MPC insists it is purely targeting inflation. It attributes its "measured [interest rate] reduction process" to subdued demand conditions and an improving trend in sticky services prices. As of the end of September, year-on-year consumer price index (CPI) was 7.12%, compared with an overly ambitious end-year target of 4%. The Central Bank (unlike the general public) believes an unchanged 4% target can be achieved in 2008.

Nevertheless, the MPC did not fail to allude to rising food prices and the possibility of increases in electricity prices and indirect taxation. It warned that future cuts would depend on several factors including global market developments and - significantly - public expenditures.

Fiscal performance has weakened in 2007, partly due to July's general election. As of September, the central government budget showed a deficit of TRY12.2bn (€7bn), compared with just TRY1.4bn in the same period of 2006. The 2007 budget bill will formally be submitted to parliament on October 17, but it is unclear whether the government intends to abide by the 6.5% of GNP target for the wider primary fiscal surplus, which has been the linchpin of successive IMF standby accords. Adding to the uncertainty, the latest IMF accord is due to expire in early 2008.

The dogfight over interest rates will continue, but Istanbul's financial markets expect the central bank to remain cautious. "The neutral rate that would reflect sovereign risk and inflation is not more than 13-14%, but I don't think they will be able to do it," says Belli.

"We expect maybe another 200 basis points in cuts between now and the third quarter of 2008 - unless conditions worsen in the US and Turkey follows the Fed in cutting rates by more than expected," predicts Emre Yigit, head of research at Global Securities.

HSBC economist Esra Erisir envisages a policy rate of around 16.25% by the end of the year and 14-14.5% by end-2008. "As long as the global environment is supportive, the real interest rate will have to decline substantially before there is any impact on the exchange rate," she notes. "The [monetary] easing process is supportive for the long end of the yield curve and for equities."

However, Global Securities' Yigit now sees limited upside for the bond market and prefers equities. But shouldn't investors fight shy of those troubled manufacturers and exporters?

"Companies listed on the ISE tend to be larger and more competitive. They will survive. But we continue to overweight banks rather than the industrial sector," says Yigit. "Generally we expect Turkish markets to perform strongly into next year but they may be more volatile both because fund inflows may be more erratic due to world conditions and because we believe we are in the final stages of a bull market."

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