- Inflation remains high at around 20%, despite tight monetary policy
- The central bank has taken controversial steps, further eroding credibility
- We adjusted our end-2019 inflation forecast upwards to 15%
- The S-400 purchase and domestically political issues (rerun of Istanbul elections) fuels market volatility
- Lira will trend higher in short-term before recovering towards 6 USD/TRY end-2019
This publication has been written in cooperation with Robert Veldhuizen from ABN AMRO Security Intelligence
Market turmoil and high inflation continues
While Turkey has weathered the currency storm in late August 2018, the dust has not settled yet and inflation remains high while the lira remains volatile. Inflation printed 19.5% in April (vs 19.7% in March and 20.5% consensus). Inflation has remained relatively flat at around 20% yoy since November 2018. Core inflation has gradually decreased from a peak of almost 25% yoy in October to a current level of 16.3%. Food prices increased to 32%, the highest level since 2000/2001 crisis and there are no signs of relief yet. Producer price inflation (PPI) remains high as well, at around 30% yoy, although having come down from its peak of 45% in September last year. PPI is driven by the latest lira depreciation as well as the rise in energy prices.
Key rate at 24% while bank rates have come down since end-2018
In the run-up to the elections on March 31, banks had been pressured not to raise rates on lira deposits too aggressively, in order to keep borrowing costs from surging. Moreover, the CBRT has provided ample net funding for commercial banks. From the peak of 24% yoy in October 2018, the weighted average interest rate on TRY deposits has come down to around 20%. Therefore, rates on bank loans have dropped significantly in the last six months, from a peak of above 35% to just above 20%. According to IIF data, credit growth has again surged in 1Q 2019, supported by state-banks that boosted lira-denominated lending. The IIF estimates that the credit impulse in Q1 is larger than the peak in 2017. This is reflected by the growth in the money supply, since the beginning of 2019.
We have adjusted our inflation expectations upwards
The surge in credit growth is not helping to curtail inflation. Moreover, inflation is pushed higher by the exchange rate pass-through of the recent lira pressures. Additionally, as Turkey is a net-energy importer, higher oil prices will continue to lift import inflation. Also, inflation expectations are not well anchored. Inflation expectations (over the next 12 months) have remained constant in the last couple of months at around 15%. We assumed the CBRT would prioritize inflation above growth, but recent events seem to suggest otherwise (see paragraph below). Given these developments, we have adjusted our basecase scenario for inflation (latest change was in October 2018: Turkey Watch: Inflation up, interest rates on hold). We continue to expect inflation to remain around 20% at least until June, however, we now think it will come down not as quickly as assumed before. Hence, we have increased our inflation forecast for end-2019 from 12% to 15%. This is in line with the inflation expectations by the CBRT (14.6% end-2019).
The central bank seems to have shifted their focus from inflation to the lira
The central bank has made some unexpected and controversial steps over the last weeks. Below we summarize the actions taken by the CBRT since the end of March:
- A week before the local elections on March 31, as the pressure on the lira increased, the central bank intervened in the currency markets by selling FX reserves without clearly communicating about it. This triggered wave of short selling as investors are aware of the fact that the FX reserves are not sufficient to cushion an attack on the lira (see: Turkey Watch – Local elections come with more uncertainty).
- As the lira came under further pressure, the central bank responded by suspending the one-week repo auctions for an unspecified period, which implied that banks could only borrow from the CBRT trough the overnight lending facility. Thereby the CBRT basically re-introduced the corridor system, which they abandoned last year because they wanted to raise transparency. Furthermore, local banks were pressured by authorities to refrain from providing liquidity to foreign investors, which caused a surge in the overnight swap rate to a peak of 1350%. When things turned to ‘normal’ after the elections, the central bank resumed the one-week repo auctions and overnight swap rates came down again.
- In the meantime the CBRT had used a substantial part of its reserves to defend the lira. The net foreign assets slumped by USD9.4bn between March 6 and March 22 to USD19.5bn. In the beginning of April, the CBRT managed to replenish the reserves to USD23bn again, however, this was done by currency swaps with local banks, misrepresenting the true level of the net FX reserves. The CBRT swapped lira for dollars and added the dollars borrowed to the balance sheet as net foreign assets. The obligation to later repay the dollars is recorded as an off-balance sheet item and thus not appears on the liability side of the balance sheet, increasing the net foreign reserves. Excluding swaps, net foreign assets stood at USD 11bn in April.
- Despite the continuing pressures on the lira and high inflation, the central bank sounded more dovish in its latest MPC on April 25. The MPC has taken ‘if necessary, further monetary tightening will be delivered’ out of its statement, indicating that an interest rate hike has become less likely.
- On April 30, the CBRT talked down its previous dovish statements by saying that further monetary tightening can be delivered if there is no slowdown in inflation. It promised to give clarification on the FX reserve issue, but failed to do so by simply stating that it is legal operation to swap with local banks.
- On May 5, the CBRT introduced another tool to bolster its reserves by borrowing gold from commercial lenders.
This ‘scrambling’ for reserves is worrisome
At the end of April, net reserves stood at around USD 25bn, although excluding swaps are estimated to be around USD 11bn. Turkey’s short-term foreign currency debt stands at USD 118bn. The CBRT also uses its FX reserves to help local lenders. It allows exporters to swap lira for favourable FX rates, provides direct sales of FX to energy importing SOEs and provides FX liquidity to the domestic market through FX deposit auctions. Given the relatively low reserves, Turkey cannot afford to deplete its reserves further by defending the currency. As investors are well aware of this fact, a little spark in, for example the tensions with the US, could easily trigger another lira sell-off. Additionally, given the high short-term external debt repayments coming up, fears of insufficient FX may pop up again, similar to the situation at end of August last year. As there is especially a large amount due in October this year, we expect some more volatility in the next months. That said, this does not imply immediate payment issues by the government, as only 21% percentage of the total short-term foreign currency debt is in the hands of the government (around USD 25bn) and roll-over rates are around 95%.
Moreover, the inconsistent and controversial actions do not help to restore investors’ confidence in Turkey. That said, we continue to think that, as elections are now behind us, political pressure on the CBRT will ease (see also Turkey Watch – it’s all about reforms, oh, and geopolitics). We hold on to our view that the central bank will keep the policy rate at 24% at least until their October meeting. The political pressures from the CBRT on banks to keep loan rates low has eased, and recently several Turkish banks have indicated that they will boost TRY interest rates on customer deposits. This will help to stabilize the lira as Turkish residents will have less incentives to convert their TRY savings into FX. The total amount of FX deposits by residents grew by over 20% over the last 7 months All in all, mainly because of increased geopolitical risks (see below), we see the lira trading slightly higher against the dollar in the short-term. Especially July may see high lira volatility because of domestic- and geopolitical issues. That said, we expect the credit impulse – which has been a key driven of lira volatility – to ease in the coming months as the local elections are behind us. On the basis of still tight monetary policy and a relatively benign external environment (no rate hikes from the Fed or ECB in 2019), we expect the lira to slightly recover towards the end of this year, reaching 6 USD/TRY end-2019.
What will continue to drive markets is (geo)politics….
Aside from the central bank policy issues, geopolitical turbulence and domestic political instability continues. Below we summarize relevant risks to the Turkish market:
- Since 2017, Turkish S-400 missile system acquisition has worried the United States and other NATO members (see Turkey watch – It is all about reforms, oh, and geopolitics). The Trump administration’s hard-line stance against acquisition threatens to sanction Turkey (under CATSAA legislation) and end its participation in the F-35 fighter jet program, if Ankara proceeds with the purchase. Vice President Mike Pence stated Turkey risked NATO membership; yet, Ankara rebukes Washington’s case against the system. Turkish Foreign Minister Mevlüt Çavuşoğlu claimed the S-400 a ‘done deal’. The first delivery of the missile system is expected in July – around the same time Trump may visit Turkey, according to Turkish officials – however, Washington is yet to confirm. In other words, time is running out – the longer there is no concessionary action or bargain, uncertainty remains that will likely continue to negatively impact Turkish markets.
- Two bills recently introduced to the U.S. Senate will further test relations. The first bill proposes sanctions against Turkish officials involved in the detention of U.S. citizens; the second bill envisions the creation of an Eastern Mediterranean Security and Energy Partnership between the U.S., Israel, Greece and Republic of Cyprus (RoC). The latter bill is significant as it excludes Turkey and involves its regional rivals, supporting the planned EastMed gas pipeline, transferring natural gas from Israel to Europe, via Cyprus and Greece (fulfilling est. 10-15% of Europe’s total gas needs) bypassing Turkish waters. Furthermore, it approves arm sales to and sides with hydrocarbon claims of the Republic of Cyprus (RoC), raising conflict risks with Turkey over North Cyprus. Ankara will continue its drilling and exploration activities while disrupting activities of energy companies operating in Cypriot waters. If passed, the bill risks further U.S-Turkey confrontation.
- On the domestic front, political stability remains particularly tenuous with the AKP successfully appealing the electoral board (YSK) to nullify its high-profile loss in Istanbul; an effort resulting in protests and small-scale scuffles in the past month. The nullification is indicative of further erosion of Turkey’s democratic politics, in particular, its credible elections. Re-runs are scheduled for 23 June.
- Within the AKP, the nullification has reportedly caused a split between Erdogan loyalists and those concerned over its political-motivation, believing it should have never been pursued in the first place. Furthermore, a spat is rumoured between Erdogan and Minister of Finance Albayrak over proposed changes to FX reserve calculations; a replacement is indicative of increased AKP-rule over fiscal and monetary policy, triggering further negative responses in Turkish markets.