A few months ago, I wrote about the need for Turkey to avoid more "self-inflicted" wounds caused by the pursuit of unorthodox monetary policies favoured by President Recep Tayyip Erdogan, especially at a time when emerging markets were already being pressured by uncertainties about the US fiscal and monetary policy outlook.
Last week provided perhaps the most vivid illustration of such “self-inflicted” damage with the firing of Turkish central bank governor Naci Agbal just hours after he raised interest rates by 200 basis points to 19 per cent.
The sacking of Mr Agbal triggered a sharp sell-off in the Turkish lira and in the stock market as well as a steep rise in Turkish bond yields when markets reopened at the start of last week. It also caused Turkish money markets to seize up.
The irony in all of this was that up until Mr Agbal’s departure, it had seemed that Turkey was starting to heed some of the lessons of the past and reap some benefit by doing so.
Mr Agbal had only been in the central bank hot seat for four months but was beginning to get ahead of financial market concerns about inflation (currently at 14.97 per cent) by raising interest rates aggressively since last November by a total of 8.75 percentage points.
Foreign investors poured billions of dollars into Turkey’s economy since November 2020 and the lira began to stabilise and even appreciate a little.
Now, with emerging markets already nervous about the recent rise in US bond yields, the timing of the latest changes at the central bank could not have been more worrisome. That Mr Agbal was replaced by Sahap Kavcioglu, an apparent economics disciple of Mr Erdogan, only made matters worse.
President Erdogan’s unorthodox views on monetary policy are well-known and controversial, holding that raising interest to combat inflation actually contributes to inflation. Mr Kavcioglu has previously written in prominent newspapers endorsing this view.
Markets are understandably concerned that his appointment could see the recent tightening in monetary policy being reversed, plus any number of other controversial policies such as back-door capital controls being introduced.
In the aftermath of the sell-off, the new governor has tried to calm markets by signalling that the fight against inflation remains the main priority and the next Monetary Policy Committee hearing on April 15 will go ahead as planned, seemingly ruling out an imminent cut in interest rates.
Given Turkey’s large external financing needs and its lack of meaningful foreign exchange reserves, this message was perhaps the only option.
However, it is still believed that the central bank will cut interest rates when it meets next month and, as such, the message was insufficient to reverse the lira's losses, which remains above 8.0 against the US dollar, a critical benchmark for confidence.
In fact, given the damage done already and concerns about a likely change of policy, investors are already speculating about further currency losses in the coming months amid bigger rises in inflation. Some analysts are targeting a move towards 10 to the dollar later this year, which will exacerbate the drain on FX reserves and risk a balance-of-payments crisis.
The ultimate irony is likely to be that in an attempt to ease monetary conditions to promote growth, the opposite is likely to be the consequence. The currency is likely to weaken much further, market interest rates and bond yields will go higher for longer (despite cuts in official rates), investors will seek to withdraw capital and businesses will struggle to borrow money for growth and investment. In the end, it may be that policy rates will even have to go higher as well.
The climate for emerging markets was already becoming more complicated by signs from the bond markets about US interest rates, so EM policymakers cannot afford any missteps.
Unfortunately, in Turkey’s case, the latest announcement suggests that it is now doubling down again on past mistakes and needlessly reopening old “self-inflicted” wounds again. Where this will lead to is very unclear, but few will imagine it ending well.
Tim Fox is a prominent regional economist and an adviser to Switzerland-based St Gotthard Fund Management