- The Turkish Central Bank has increased the Late-Liquidity Window rate by 300bp…
- … and finally changed its interest rate framework to a single benchmark rate regime
- This has set the lira on a stronger footing for now…
- … but Turkey is fighting the symptoms and a correction will take place
The lira has had a wobbling path over the last month. It lost around 10% versus the dollar since the beginning of May. As already stated in our recent Short Insight (Turkey: from fragile to failing? ) this was on the back of a strengthening dollar and rising US interest rates in combination with Turkey specific concerns (overheating of the economy and political issues). We thought the central bank would take action, and they did even earlier than we anticipated. On May 24, the Central Bank of Turkey (CBRT) raised the Late Liquidity Window rate by 300bp (to 16.5%) in an emergency meeting to stop the falling lira. This move was larger than we had expected (and lower than market consensus), therefore providing a positive signal to markets.
The lira sell-off has been stopped, but lira remains volatile
As we predicted, the CBRT action provided support to the lira. The lira hit an all-time low of 4.9 against the dollar just before the CBRT’s announcement, while afterwards strengthening to 4.5. The lira dropped again after the market realised that one rate hike might not be enough. Despite the hike, the real policy interest rate in Turkey (2.5%) still stands below the real interest rates of other EMs such as Russia, Brazil, India and South Africa. On top of that, on May 25, IMF Managing Director Lagarde urged President Erdogan to preserve the independence of his country’s central bank. On the same day, the lira swung up and down again after the CBRT said it would allow exporters to repay dollar debt in local currency, limiting the impact of the falling lira on Turkish exporters. Last Monday the announcement of the CBRT to change their policy rate regime to one benchmark rate, helped to set the lira on a more sustainable footing, as investors interpreted the move as a sign of independence, and willingness of the CBRT to support the lira.
Simplification of the interest rate policy strengthened trust
Under the new policy rate regime, the benchmark will be the one-week repurchase rate, which will be increased to 16.5% (more than double the current level). Overnight borrowing and overnight lending rates will be set 150 basis points below and above the one week repo rate, to 15% and 18% respectively. The CBRT also announced that the late-liquidity rate will be raised by 300bp from June 7 onwards (to 19.5). Moreover, the late-liquidity rate will regain its original function, as emergency rate for daily liquidity needs of banks, instead of the only source of funding. This gives more policy certainty: with the current corridor system, policy makers can adjust the cost of cash provided to commercial banks on a daily basis. In the new system, this is fixed. Note that it will not change the average cost of funding substantially as under the current system, the late-liquidity window also stands at 16.5% (similar to the new benchmark one-week repo rate).
Relief on the short-term, but Turkey’s troubles are not over
The interest rate hikes and the more understandable policy framework did reassure markets that Turkey retains its independent monetary policy and is able to overcome a devaluation crisis. However, by doing so Turkey is (again) fighting the symptoms and not the disease. The lira is weakening on the back of deteriorating fundamentals; high inflation (10.8%) and a high current account deficit (around 6%). The latter is not expected to come down anytime soon, as exports to the Eurozone are unlikely to grow substantially while higher oil prices drive imports up. Moreover, inflationary pressures are not going to abate soon; with inflation expectations continue to trend above 10%. Moreover, the upcoming elections will add even more political unrest to the mix.
We are increasingly concerned about the sustainability of Turkey’s growth path. Several indicators are reaching worrying levels. The current account deficit is to a large extent financed by short-term portfolio flows (70%). External debt has increased, nearly doubling in absolute terms over the past 10 years to a current level of around USD450bn (53% of GDP). The corporate sector’s foreign currency debt (around 40% of GDP) is rising as the lira continues to weaken. While total gross FX reserves are mediocre at around USD90bn (approx. four months of import), the net FX reserves are estimated to be only around USD34bn (See also: Turkey Watch: Early elections and building vulnerabilities). Furthermore, leading sectors such as the real estate and manufacturing are showing the first signs of contraction. In the long-term, the current growth trajectory is unsustainable and a correction has to take place. Whether that will be triggered by (painful) reforms, or an economic crisis is yet to be seen.