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Analysis

Turkey’s interest rate dilemma

by Aslihan Gedik

Turkey’s interest rate dilemma

 

Last year was extremely challenging for Turkey. The country, having come under terror attacks by the Kurdistan Workers’ Party for decades, is now dealing with the militants targeting civilians in major cities. It is also increasingly threatened by Isis.

All of this is in addition to the attempted military coup of 15 July 2016. This brought the country into a state of emergency that is still in place. The next major step is the constitutional referendum on 16 April.

The Turkish lira has depreciated by more than 20% since November’s US presidential election. Most of the depreciation reflects Turkey’s high sensitivity to fluctuations in global financial conditions and low oil prices. Recent weakness has been driven by market concerns about the Central Bank of the Republic of Turkey’s (TCMB) policy intentions. In practice, however, the TCMB has the means to stabilise the lira.

Most of the flows out of lira-denominated assets are driven by return considerations, and can be addressed by raising interest rates. However, the authorities prefer a weaker real exchange rate, which would put the economy on a more solid external footing. Hence the reluctance to tighten policy. Given that Turkey needs to reduce its dependence on external borrowing, such a strategy seems plausible. This suggests that we will see more decisive action from the monetary authorities once the lira is deemed weak enough.

Decisive action from monetary authorities
The lira is now 30% undervalued compared with fair-value estimates. It is hard to see why this should not be sufficient to encourage monetary action. With the exception of the 2001 Turkish banking crisis, this is the lira’s weakest level in real terms in 20 years.

Although a short-term appreciation is likely to be necessary to stabilise local flows, it is hard to argue that the lira would need to weaken much further still. Interest rates would have to rise temporarily by at least 2-2.5 percentage points to stabilise the exchange rate, and would have to remain at around 10%-11% until inflation began to fall.

Rates will have to rise sharply, but should subsequently ease fairly quickly. The Taylor rule, which estimates the sensitivity of interest rates to changes in economic conditions, suggests that rates will have to rise to close to 11% to stabilise the lira and then fall towards 9.5% by year-end to reflect tighter global financial conditions.

Lira stabilisation using rates
This tightening could be delivered by increases in the main policy rate and a widening of the interest rate corridor. The nature of the flows that lead to depreciation is still returns-driven, and hence can be stabilised using rates. This is consistent with the pricing in the sovereign credit default swap market and in the equity market in local currency, which have been relatively stable.

This view is consistent with the intra-week response of the lira, which fell sharply when the TCMB injected dollar liquidity while government officials were restating their opposition to higher interest rates. The currency then stabilised when the central bank did not open its seven-day repo auction. The Bank’s inaction raised the average cost of funding, and indicates that the TCMB could tighten policy if needed.

Given the size of the shocks to the economy, Turkey’s growth outlook is, at best, uncertain. Additionally, the Turkish Statistical Institute has published revised GDP figures. According to the revisions, Turkey’s national savings rate is significantly higher than previously thought, arguably facilitating the adjustment of the current account towards a sustainable level.

The sharp slowdown in domestic demand, coupled with the much weaker exchange rate, should result in a much-reduced current account deficit. While the size of that improvement is dependent on the potential for a recovery in tourism revenue, the deficit is expected to fall to 3% of GDP.

Globally, Donald Trump’s win in the US presidential election has introduced much economic and policy uncertainty. Following years of abundant liquidity and positive external conditions that have benefited Turkey’s current account position since mid-2014, the external environment is becoming negative.

Accordingly, Turkey will confront at least two external shocks in 2017: a potential 25% rise in oil prices, and a secular shift in global capital flows towards developed markets. This points to a wider current account deficit next year coupled with higher financing costs.

State of emergency
Domestic conditions are similarly unsympathetic. The state-of-emergency conditions and purge of coup-plotters are blurring Turkey’s investment and consumption outlook. This is in addition to rising political volatility ahead of the public referendum on transforming Ankara’s parliamentary system into an executive presidency.

Relations with the European Union have been strained, as illustrated by the European parliament’s non-binding vote in November 2016 to freeze Turkey’s accession talks.

External pressures, a rising inflation differential against trading partners, the absence of geopolitical clarity, and a wider current account deficit all point to further lira volatility in 2017. 

Aslihan Gedik is a Deputy General Manager of the OYAK Anker Bank.

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