Central Bank Gamble Won't Pay Off

BMI View: Although the Central Bank of Turkey has indicated its rate hiking cycle has come to an end, it has not done enough to restore confidence in its monetary policy and stabilise the lira. With under three months of import cover, ongoing FX reserve sales will prove insufficient to stem capital outflows and lira depreciation, and we continue to believe a 50 basis point hike to its main policy rate will be necessary before end-2013.

Despite a sharp and sustained sell-off in the Turkish lira that risks stoking inflation and exacerbating capital outflows, the Central Bank of the Republic of Turkey (CBRT) has gambled that its recent monetary policy tightening measures will prove enough to stabilise investor sentiment. On September 4 CBRT Governor Erdem Basci reiterated his commitment to leaving policy rates at current levels while signalling a greater tolerance for lira weakness. By ruling out the use of its most effective policy tool and failing to announce any significant change to its strategy of using its relatively meagre FX reserves in defence of the lira, we believe the CBRT has ensured volatility will remain elevated. In our view, the CBRT has not yet done enough to restore confidence in its monetary policy, which has been damaged by its complexity and perceived pro-growth bias, and continue to believe a hike to the main policy rate will be necessary to stabilise the lira before end-2013.

The CBRT utilises an interest rate corridor that allows it to adjust the cost and duration of liquidity it offers on a day-to-day basis. As such, the weighted average cost of CBRT funding ( see chart) is the best gauge of policy rates. Viewed in this way, the CBRT has brought its policy rate from a low of 4.52% on May 31 to as high as 7.16% on August 23, a 264 basis point change since capital outflows began accelerating. This means that the CBRT has tightened policy on par with other current account deficit emerging markets such as Brazil and Indonesia, whose central banks have hiked policy rates to stabilise their currencies.

Lira Sell-Off Not Over Yet
Turkey - CBRT Interest Rate Corridor & TRY/US$ Exchange Rate

Central Bank Gamble Won't Pay Off

BMI View: Although the Central Bank of Turkey has indicated its rate hiking cycle has come to an end, it has not done enough to restore confidence in its monetary policy and stabilise the lira. With under three months of import cover, ongoing FX reserve sales will prove insufficient to stem capital outflows and lira depreciation, and we continue to believe a 50 basis point hike to its main policy rate will be necessary before end-2013.

Despite a sharp and sustained sell-off in the Turkish lira that risks stoking inflation and exacerbating capital outflows, the Central Bank of the Republic of Turkey (CBRT) has gambled that its recent monetary policy tightening measures will prove enough to stabilise investor sentiment. On September 4 CBRT Governor Erdem Basci reiterated his commitment to leaving policy rates at current levels while signalling a greater tolerance for lira weakness. By ruling out the use of its most effective policy tool and failing to announce any significant change to its strategy of using its relatively meagre FX reserves in defence of the lira, we believe the CBRT has ensured volatility will remain elevated. In our view, the CBRT has not yet done enough to restore confidence in its monetary policy, which has been damaged by its complexity and perceived pro-growth bias, and continue to believe a hike to the main policy rate will be necessary to stabilise the lira before end-2013.

The CBRT utilises an interest rate corridor that allows it to adjust the cost and duration of liquidity it offers on a day-to-day basis. As such, the weighted average cost of CBRT funding ( see chart) is the best gauge of policy rates. Viewed in this way, the CBRT has brought its policy rate from a low of 4.52% on May 31 to as high as 7.16% on August 23, a 264 basis point change since capital outflows began accelerating. This means that the CBRT has tightened policy on par with other current account deficit emerging markets such as Brazil and Indonesia, whose central banks have hiked policy rates to stabilise their currencies.

Lira Sell-Off Not Over Yet
Turkey - CBRT Interest Rate Corridor & TRY/US$ Exchange Rate

However, we believe the complexity of CBRT policy has reduced the effectiveness of such tightening, while the ability to lower rates within the corridor appears to confirm the CBRT's pro-growth bias. In addition to the variation in its liquidity offerings, the CBRT targets multiple objectives within its mandate of price and financial stability ( see 'Central Bank Credibility At Risk', March 13). Taken together, this serves to confuse market participants and reduce the credibility of the CBRT's stated objectives. We believe this is a significant factor in the recent lira sell-off, which has continued relatively unabated despite what can be viewed as a fairly significant tightening by the CBRT thus far.

Furthermore, unwilling to choke off economic growth with further rate hikes, the policy of tolerating FX weakness risks keeping inflation elevated and well outside the bounds of CBRT target levels. With the lira down 13.8% since May 9, exchange rate pass through effects will continue to put upward pressure on domestic prices. As a massive net energy importer, this will be most acutely felt through energy prices, which have been rising as the potential for a military strike in Syria becomes more likely.

Energy Prices To Keep Pressure On Inflation
Brent Crude, TRY/bbl

However, energy prices alone cannot account for the recent uptick in prices. Beginning in May, core inflation has reversed a multi-year downtrend, reaching 6.8% year-on-year (y-o-y) in August. While lira depreciation has most likely contributed to this reversal, inflation in the largely non-tradeable services sector grew to 7.7% y-o-y in August, indicative of underlying demand side pressures also driving inflation. In our view, still-elevated credit growth, which as run close to 30% y-o-y for most of 2013, has contributed to this trend. With credit still running well above the CBRT target range of 15%, this bolsters the case for further tightening. On the back of these concerns, we have revised up our average inflation forecast in 2013, from 6.5% to 7.3%.

Core Inflation Sends Worrying Signal
Turkey - Consumer Price Inflation & Core Consumer Price Inflation

The CBRT, who has sold US$8.8bn of its FX reserves since June in defence of the lira, has confirmed its intention to continue pursuing this strategy. However, with approximately US$54.5bn left in its net international reserves and an average of US$21.6bn of monthly imports, continuing FX auctions with just under three months of import cover will put the lira under continued selling pressure as investors lose confidence in the CBRT's ability to continue defending the currency.

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