The Turkish central bank’s unorthodox monetary policy is so far failing to stem the steep plunge in the value of the lira.
The central bank of Turkey refrained from raising its benchmark one-week repo rate on January 24 but hiked the upper band of the interest rate corridor, disappointing investors and analysts who had expected a more orthodox 50bps increase in the key rate.
“The rate hikes are below what we believe is needed to stabilise the lira,” said J.P Morgan. A 200-250bps tightening is required in the current environment, according to the investment bank.
The currency, which has been under strong selling pressure because of a toxic combination of political uncertainties, geopolitical risks and economic woes, immediately sank 1.6% on January 24 following the rate decision, though it pared most of its losses to close the day 0.5% lower against the greenback. On January 25 it fell more than 1% to trade at 3.826 per dollar as of 17:00 Istanbul time.
The lira has lost nearly 8% of its value since the start of the year, following last year’s 17% plunge. That presently makes it one of the worst performing emerging market currencies.
To arrest the lira’s decline, the central bank has tightened monetary liquidity via unorthodox measures in recent weeks, forcing local banks to borrow through a more expensive late liquidity window facility, an “implicit rate hike”. It stopped conducting one-week repo auctions, reduced lenders’ borrowing limit on its interbank money market to TRY11bn, and launched forex swap transactions “with the aim of enhancing flexibility and instrument diversity of the Turkish lira and FX liquidity management”.
On January 24 the bank kept its benchmark one-week repo rate at 8% while increasing the overnight lending rate from 8.5% to 9.25%. It left the overnight borrowing rate at 7.25%, yet raised the late liquidity window rate from 10% to 11%.
The national lender assured the markets that it stands ready to deliver further monetary tightening if needed to defend the currency. “Necessary liquidity measures will be taken in case of unhealthy pricing behaviour in the foreign exchange market that cannot be justified by economic fundamentals,” it said in a statement released after this year’s first Monetary Policy Committee (MPC) meeting.
The wording in the statement implies that the bank believes the lira’s troubles are only temporary and the run on the currency is due to speculative attacks.
Growth vs currency
For some analysts, the January 24 meeting of MPC also represented a test for the central bank’s independence from government pressure.
The ruling AKP owes much of its sweeping election victories over the past decade to strong economic growth; thus a weak economic outlook is the last thing the governing party needs when the country is fast moving towards a popular vote on the constitutional changes.
Politicians fear that higher rates, and resulting costlier loans, will curb investments and domestic consumption in the run-up to the planned April referendum in which voters will be asked to deliver an executive presidency.
The central bank contends that “with the supportive measures and incentives provided recently, the recovery in the economic activity is expected to continue at a moderate pace”.
Earlier this month, the World Bank slashed its 2017 GDP growth projection for Turkey to 3% from its previous forecast of 3.5%, citing political uncertainties and financial market volatility. The government’s GDP growth estimates for this year and next year are 4.4% and 5%, respectively.
“We expect Turkey’s central bank to hold the benchmark repo rate unchanged on 24 January as political pressure to keep the economy growing prevails.” Danske Bank had commented in a note published ahead of the MPC meeting.
Goldman Sachs meanwhile argues that the authorities prefer a weak lira in order to put the economy on a more solid external footing.
It remains to be seen whether the weaker lira will give a boost to Turkish exports, which fell by 0.84% to $143bn last year when the lira plunged 17%.
There could be one noticeable casualty from the lira’s decline: inflation.
The central bank admits that “excessive fluctuations in exchange rates have increased the upside risks regarding the inflation outlook”. “The significant rise in inflation is expected to continue in the short term due to lagged pass-through effects and the volatility in food prices.”
Inflation ended 2016 at 8.53%, well above the official target of 5%, which is also this year’s target. But the bank counts on sluggish domestic demand to take inflation under control. Aggregate demand developments support disinflation, it says.
Obviously, the restrictive liquidity measures currently implemented cannot go forever and the central bank may start to employ more orthodox policies if normalcy returns to the country after April’s referendum.
“Once this [referendum] process is over, pressure on the lira will be lifted and, given our expectation that inflation will moderate towards the end of year after a strong rise in prices in the first half, an easier monetary policy stance may follow in the second half of the year,” argued Goldman Sachs.
Investor will keep guessing how the central bank could respond to the developments in Turkey and in global financial markets.
The central bank would hold monthly rate-setting meetings until this year, but from this year on the MPC will convene at least eight times. The central bank has not posted on its website a schedule for the upcoming meetings that could add to uncertainties.
The bank pledged in December that it would hold technical meetings with investors and analysts, and regular meetings with investors in financial centres abroad as part of its communication policy.
Analysts at J.P Morgan believe a more orthodox policy response could help to reverse credibility erosion and to anchor inflation expectations in a more meaningful way. However, they say, in the current environment, the tightening delivered by the central bank could suffice to stabilize the currency.
J.P Morgan still asks what happens if global sentiment sours or if inflation picks up sharply in the next 2-3 months. They respond: “It seems that the CBRT will have a reactive rather than a proactive stance and will first tighten the liquidity and then deliver further rate hikes if/when the lira comes under pressure.”
William Jackson, senior emerging markets economists at Capital Economics, argues that the central bank’s rate decision this week may prevent the lira from sliding further in the very near term, but this won’t last. He sees the currency ending the year at 4.00/$.
“Concerns that this will push up already-high inflation and raise the private sector’s FX debt burden would argue in favour of additional rate hikes. Ultimately, we think the government will be forced to soften its stance. We see at least 75bp of hikes in the key policy interest rates in the next few months,” said Jackson in an emailed note.