- We think the central bank will hold rates steady on 24 July
- Erdoğan has tightened his grip on the central bank…
- … and higher interest rates do not fit with Turkey’s growth strategy
- Holding rates steady will mean higher inflation, lower spending power, and a higher risk of an external debt crisis
After President Erdoğan was re-elected in the first round of the presidential election on 24 June (See Turkey Watch: a most decisive moment), he selected his son-in-law, Berat Albayrak, as the new finance minister on 9 July. Investors were hoping to see market-friendly personalities such as Mehmet Simsek return to important positions, but Erdoğan has come up with a cabinet full of his loyal followers. Erdoğan thereby confirmed the concerns of the market that he would implement his own unorthodox views on the economy and the central bank, which includes lowering interest rates while inflation is high (15.4% in June) and the current account deficit trending upwards (6.5% of GDP). That said, there is speculation that market-friendly Naci Agbal will be heading the newly created Budget and Strategy Department.
The central bank communication on 24 July will be an important signal to the markets. Will the monetary policy committee, despite political pressure, increase interest rates? The independence of the central bank has been questioned before. But they did what they had to do (albeit somewhat late) by hiking 500bp since April to the current level of 17.75%. Investors hope that 24 July will not be different. The market is pricing in a sizable interest rate hike, 100bp. We are not convinced that the central bank will act. Given the tight grip of Erdoğan on the central bank and as higher interest rates do no fit with Turkey’s economic growth strategy, we expect the Turkish central bank to keep the one-week repo rate on hold at the monetary policy meeting on 24 July.
Why are higher interest rates such an issue?
Let’s take a step back: Why is raising interest rates in an environment where inflation is high and the currency under pressure such an issue? Erdoğan’s aim is to improve the economic position of households. Broadly, that can be achieved by pursuing two strategies: 1) making sure that the total pie grows, so everyone benefits (i.e. stimulating economic growth); 2) lowering inflation and thereby increasing the total spending power of households. It isn’t a secret that Erdoğan has opted for option 1. In this line of reasoning, Erdoğan has succeeded (so far) by setting-up the Credit Guarantee Fund (CGF) and increasing fiscal spending. The CGF is estimated to add around 2% to the 7.4% GDP growth in 2017. The fund is being extended into 2018, with an injection of TRY55bn. In the first quarter of 2018, GDP growth was higher than consensus, at 7.4% yoy, supported by a sizable fiscal impulse in the form of larger outlays on capital spending, public wages and pensions. While the government deficit increased to 2.2% in 1H2018, from 1.3% a year earlier, the economy is growing at a fast pace.
Higher rates don’t fit with the government’s growth strategy…
Higher interest rates would endanger the growth picture and an abrupt switch from strategy 1 to strategy 2 would likely trigger a sudden crisis. Best to keep the music playing, whilst internal and external imbalances are growing. And, as Erdoğan may reason, if capital is heading for the door he should not waste too much resources defending the currency, especially since FX-reserves are low (3 months of import). Growth is after all the best solution for decreasing debt and to attract foreign investors (high returns).
…which is reaffirmed by Erdoğan’s actions
Consistent with the above reasoning, Erdoğan has repeatedly stated that he believes interest rates do not curb inflation and that the current one-week repo rate is already too high. The interest rate hikes of 500bp have not prevented the lira from sliding further, nor curbed inflation (although the situation may have been worse today if they had not taken action). Erdoğan may use these figures to argue that the interest rate mechanism doesn’t deliver. He may feel the nominal anchor is lost, and so if the CBRT hikes in the next MPC meeting, markets will again price in more interest rate hikes, resulting in a negative spiral. Furthermore, by claiming the exclusive power to appoint the central bank rate-setters, Erdoğan has, more than ever, tightened his grip over the central bank.
Our expectation of steady rates means that more trouble lies ahead
One of the problems Erdoğan faces is that high inflation is eroding household incomes. As inflation is much higher than wage growth, at 11.6% vs 7.5% respectively, households do not benefit from the economic growth strategy. The savings rate is low in Turkey and spending power will decline even further.
Furthermore, keeping rates on hold will result in another sharp depreciation of the lira. The current account deficit is pushing towards 6.5%, and Turkey’s annual external financing requirement – reflecting the current account deficit and maturing debt – sits at USD218bn and will increase to USD240bn this year according to the IIF (28% of GDP). Therefore, the risk of an external debt crisis will increase further (see also: Turkey Watch: Turkey in crisis) and we will continue to see higher inflation on the back of higher import costs.