Ratings agencies Moody’s Investors Service and S&P Global Ratings on August 7 warned Turkey that it will likely have to raise interest rates sooner or later as it runs out of options to defend the Turkish lira, which has sunk to new depths against the dollar this week.
Ankara’s response to the floundering lira—which hit a fresh all-time low of 7.37 against the USD on August 7 as market players continued to worry the stark depreciation might bring on Turkey’s second balance of payments crisis within two years—was to move to use more backdoor policy tightening in an attempt at stabilising the currency.
“Turkey has been muddling through for some time now, but muddling through is not a strategy that can be used for ever. At some point they will run out of road,” Sarah Carlson, lead sovereign analyst at Moody’s Investors Service, told Reuters in an interview.
Maxim Rybnikov, associate director at S&P Global Ratings, told the news agency that the central bank had already eroded Turkey’s foreign exchange reserves this year, leaving limited room for manoeuvre with interventions. It was anticipated that usable foreign exchange reserves would drop below $10bn this year from around $30bn last year, he added.
Many foreign investors have already fled Turkey, with non-resident participation in domestic government bonds at a record low of 4%, Rybnikov was also cited as saying, adding that official data showed foreign currency held by locals swelled to $212.92bn at the end of July, continuing a trend of dollarisation.
“If domestic Turkish residents lose faith, starting to increasingly convert to FX, this can also precipitate a balance-of-payments stress,” Rybnikov also observed, drawing comparisons with Azerbaijan in 2015 and more recently Argentina.
‘Cost is short-term pain’
Policymakers were faced with having to weigh up introducing reforms that could deliver long-term gains but at the cost of short-term economic pain, said Moody’s Carlson, warning that hiking the policy rate—currently at 8.25% versus annual inflation of near 12% after a year-long ultra-aggressive easing cycle at Turkish President Recep Tayyip Erdogan’s behest that slashed 1,575 bp from the key rate—may not resolve underlying challenges.
“The fundamental problem is a chronic shortage of domestic savings relative to investment needs in the country,” she said.
Moody’s was concerned about a rise in the government interest payments to government revenues ratio, a key debt sustainability metric, said Carlson, describing it as a huge and rather unusual move.
Erdogan on August 7 showed no sign of finding common ground as regards the advice of the major ratings agencies, telling reporters after attending Friday prayers that the coronavirus (COVID-19) pandemic and this week’s devastating explosion in Beirut were behind the lira’s sharp drop. “Turkey’s economic system is steady. Sometimes there will be rises and falls,” he said. “These fluctuations are temporary.”
“There are those who are blind”
Meanwhile, the hashtag “Berat Albayrak is not alone” was trending on Twitter in Turkey as top government officials and others defended the finance minister, who is Erdogan’s son-in-law, in the face of criticism that his policies have led to the lira’s sharp decline and calls from tens of thousands on social media for his resignation. Erdogan said anger over Albayrak’s handling of the economy was a case of “sour grapes”. “Turkey is flying, but there are those who are blind to this reality,” Erdogan added. Erdogan has long hit out at high interest rates as “the mother and father of all evil”, and insists that his unconventional view that higher rates drive inflation is correct.
The Erdogan administration has run into trouble by adopting the same policy that led to the August 2018 Turkish lira crisis, namely flooding the economy with cheap credit for consumers and companies to drive growth. Whenever the lira takes a dive—it is down by around 20% against the dollar so far this year—Turkish officials claim there are shadowy conspiratorial forces who desire to brew a financial crisis to undermine the country. This time around ruling Justice and Development Party (AKP) spokesman Omer Celik said in a tweet on Friday. “Our struggle against legionnaire politics aimed at tying down our economy, security and foreign policy . . . will continue.”
Such a blame game does not go down well with market players who would rather see the government get a realistic grip on the situation. “Erdogan suggesting it’s everything else’s fault, other than domestic policy, will not relieve the market at all,” said an emerging market portfolio manager quoted by the Financial Times.
Convincing the markets the practical front is seeing some meaningful action was very much the job of the central bank on August 7. It was at least able to announce some moves that will have the effect of tightening monetary policy, with the lira subsequently recovering to 7.29 by the end of the day.
The central bank said it had ceased funding local lenders from its one-week repurchase rate, forcing the banks to borrow from its more expensive overnight window. If sustained, the tactic will delier a 150 bp rate hike.
While the measures eased some pressures on the currency, “the central bank still has more work to do,” analysts including Ned Rumpeltin at TD Securities in London, wrote in a note to clients. “Turkey’s monetary policy is too loose and we expect the central bank will be forced to hike rates dramatically—and possibly take other measures.”
Regulators were also moving to withdraw rules that compelled lenders to boost credit, according to people familiar with the matter who spoke on condition of anonymity to Bloomberg.
Recent days have also seen the central bank take steps to raise the average rate of funding to 7.88% from mid-July’s 7.34%. The funding rate was sharply cut in March to limit economic impacts of the pandemic. The facilities providing such liquidity would be phased out as of early August, the Central Bank said. Goldman Sachs analysts anticipated the regulator lifting the average funding rate to the level of the policy rate of 8.25%.
“The danger is that all of this is just window dressing,” Timothy Ash, a strategist at BlueBay Asset Management in London, said of the response so far to the lira’s turbulent descent. “Ultimately, only proper rate hikes will reassure markets.”
Piotr Matys, senior emerging markets FX strategist at Rabobank, said Turkey needed a fresh strategy to stabilise the lira. “A weak currency will be the source of inflationary pressures and may undermine the still fragile confidence amongst households and corporates following the shock caused by the coronavirus pandemic,” he added.
In another development, there were numerous reports that banking regulator BDDK had consented to requests from lenders to lower the asset-ratio rule introduced earlier this year to push financial institutions to lend more, purchase government bonds and engage in swap transactions with the central bank.
Turkey has experienced a debilitating outflow of foreign cash from shares and bonds as officials made it more and more difficult for foreign banks to borrow lira in order to protect the currency from unfavourable trades. The August 6 announcement that global investment banks will now not face such restrictions–despite strict conditions attached on what the banks can do with their obtained lira—indicate that the authorities may have given up on this attempt to defy global market mechanics.
“Turkey may be recognising that its pre-existing strategy was unsustainable,” said Phoenix Kalen, a strategist at Societe Generale in London. “We don’t believe that we’re likely to see an emergency rate hike enacted soon, as this would be an indefensible admission of failure in markets strategy,” she said, adding that she could not see the government refraining from interventions.
Looking at whether the latest lira stress could spell the end of unorthodox ‘Erdoganomics’, Erik Meyersson, senior economist at Swedish bank Handelsbanken, said hiked interest rates might do nothing to sway Erdogan’s approach to the economy. “At this point I wouldn’t be surprised if we get another mass hike, but don’t expect a change in the ‘framework’,” Meyersson said on Twitter. “Another mass hike however would require someone to fall on their career sword.”
Flouting the teachings
Ahval quoted an analysis issued last week by Desmond Lachman, a former deputy director at the International Monetary Fund (IMF), which said that Erdogan was flouting the teachings of the world’s most renowned economists such as Nobel laureate Milton Friedman by insisting higher interest rates were inflationary and seeking to fix the value of the lira.
Lachman drew attention to Turkey’s external debts of $450bn and its highly indebted corporate sector, which has more than $300bn in borrowings. The companies would have difficulty servicing those FX obligations should the lira plunge to new lows, raising pressure on an already fragile banking system, he said.
“For the sake of the global economy, and especially for the sake of the poor Turks who have to bear the brunt of Erdogan’s policies, we should all hope that he will prove Friedman and a host of other economists wrong,” Lachman said. “Not that I’d bet on it.”