With the United States Congress in recess, major markets were steady last week as they awaited US fiscal stimulus plans. This saw the attention switch to emerging markets, with the Turkish lira in particular in the spotlight amid recent sharp declines.
Despite the lira recording a 3.3 per cent fall since the beginning of August, a 5.4 per cent fall over the whole of July, and an 18 per cent fall since the start of the year, the Turkish central bank left interest rates unchanged at 8.25 per cent at its monthly policy meeting on August 20, defying analysts who had recommended a hike of between 150 to 300 basis points.
Although this was not a huge surprise given the central bank’s record of holding out against monetary policy tightening in the face of rising inflation, such an approach carries the risk of Turkey repeating the errors of two years ago, when currency weakness eventually forced much bigger rate hikes than would have otherwise been necessary.
Inflation may be a lot lower than it was in 2018, when it reached just above 25 per cent, but at 11.8 per cent year-on-year, today it is again on an upward trajectory without any offsetting brake coming from monetary policy, with Turkey’s real policy rates among the lowest in the emerging world.
But it is not only inflation that investors are worried about. Concerns are also mounting about depleted currency reserves, costly foreign currency interventions, a looming balance-of-payment crisis, and rising coronavirus cases that are hurting economic growth, with the International Monetary Fund forecasting a 5 per cent contraction this year.
President Recep Tayyip Erdogan’s desire to counter the Covid-driven growth threat is entirely reasonable, but his track record of backing unorthodox economic policies does not help Turkey gain the confidence of investors, especially as these policies often deliver additional “self-inflicted” economic wounds over time.
In the past year, Erdogan has attempted to stabilise the economy in the face of the Covid-19 downturn by cutting interest rates and easing credit while also supporting the lira. This started before Covid-19 hit the world, but accelerated after it with interest rates falling from 12 per cent at the end of last year to 8.25 per cent in May.
The explosion in credit led to inflation turning higher and demand for imports, putting additional pressure on the Turkish lira, itself also inflationary. This in turn forced the central bank to intervene aggressively to support the currency, but to no avail with the institution spending $65 billion (Dh238.7bn) this year on defending the lira, according to Goldman Sachs, only to see it reach new lows.
Such intervention might have some credibility if it were backed up by the threat of monetary policy tightening, but the markets also know that President Erdogan opposes this, controversially seeing high interest rates as actually fuelling inflation. That the President is involved in monetary policy at all is worrying enough, and that he is a proponent of unorthodox policy views on interest rates only deepens such concerns.
This approach in 2018 meant that interest rates were raised too late, after inflation had already surged. In the end, this caused policy rates to peak at 24 per cent, much higher than otherwise would have been needed.
This time around, the central bank has again enacted unorthodox “liquidity measures” to attempt to tighten monetary policy so policy rates can remain at 8.25 per cent – a process that has been described as “backdoor” tightening by some analysts.
The central bank said it is increasing mandatory reserve ratios for lenders that meet certain requirements for credit growth, but this failed to reverse the lira’s losses. On Friday, it had to take another step towards tightening officially by raising the weekly lira-dollar swap rate to 9.75 per cent from 8.25 per cent.
Notwithstanding the discovery of a big natural gas find in the Black Sea, these announcements will have a limited impact in terms of improving sentiment, unless the government also gets to grips with the inflation threat, something the markets know Erdogan is loath to do.
The signs are increasingly ominous that Turkey is starting to go down the same road it travelled in 2018 and while there is understanding of the problems caused by the coronavirus, it is the “self-inflicted” wounds that the markets are worried about.
Tim Fox is a prominent regional economist and financial market analyst