Hike Can't Hide Economic And Political Fragility

The Central Bank of Turkey (CBRT) exceeded consensus expectations with a 425-550 basis point (bps) hike to its interest rate corridor at an emergency monetary policy committee meeting on January 28. While this will stem the lira's underperformance for now, the external environment for Turkey will remain challenging as slowing growth, elevated political instability and rising US yields continue to weigh on demand for lira-denominated assets.

Rate Decision Not Quite As Bold As It Seems

The CBRT hiked its overnight lending rate from 7.75% to 12.00%, its one week repo rate from 4.50% to 10.00%, and its deposit rate from 3.50% to 8.00%. Crucially, it has signalled that the one-week repo rate of 10.00% will now be the primary funding mechanism of the banking sector, whereas before it was the overnight lending rate of 7.75%. As such, from the perspective of banks the effective rate hike can more accurately be interpreted to be in the range of 225-300 bps, based on the likely increase in the weighted average cost of funding that the CBRT provides to the sector ( see chart).

Aggressive Tightening
Turkey - Weighted Average Cost Of CBRT Funding To Banking Sector, %

The Central Bank of Turkey (CBRT) exceeded consensus expectations with a 425-550 basis point (bps) hike to its interest rate corridor at an emergency monetary policy committee meeting on January 28. While this will stem the lira's underperformance for now, the external environment for Turkey will remain challenging as slowing growth, elevated political instability and rising US yields continue to weigh on demand for lira-denominated assets.

Rate Decision Not Quite As Bold As It Seems

The CBRT hiked its overnight lending rate from 7.75% to 12.00%, its one week repo rate from 4.50% to 10.00%, and its deposit rate from 3.50% to 8.00%. Crucially, it has signalled that the one-week repo rate of 10.00% will now be the primary funding mechanism of the banking sector, whereas before it was the overnight lending rate of 7.75%. As such, from the perspective of banks the effective rate hike can more accurately be interpreted to be in the range of 225-300 bps, based on the likely increase in the weighted average cost of funding that the CBRT provides to the sector ( see chart).

Aggressive Tightening
Turkey - Weighted Average Cost Of CBRT Funding To Banking Sector, %

However, other key elements of the decision bolster the hawkish tone. Given the flexibility provided by the interest rate corridor, the CBRT retains the option to increase funding costs towards 12.00% in the case of excessive lira volatility. Furthermore, by making the one-week repo the primary policy tool, the CBRT has effectively surrendered the option of covert easing via changes to the weighted average cost of funding, which previously fluctuated between 4.50% (one-week repo) and 7.75% (overnight lending rate).

Lasting Damage To CBRT Credibility

By exceeding consensus expectations and adopting a decidedly hawkish stance, we do believe that the move was sufficient to restore some confidence in the CBRT and stabilise Turkish financial markets for now. However, given the prominent structural challenges facing Turkey as global liquidity conditions continue tightening in the coming quarters, the CBRT's panicked and delayed response to destabilising lira depreciation has in our view done serious damage to its credibility. Furthermore, frequent changes to inflation forecasts, policy rates and FX targets over the past year will reduce its ability to credibly communicate monetary policy in the future, with negative long-term negative implications for effective inflation targeting.

Limited Upside For Lira

We see the rate hikes as sufficient to stabilise the lira and end its recent underperformance relative to emerging market peers. Crucially, increasing the deposit rate from 3.50% to 8.00% will significantly boost the carry appeal of the currency.

Correction Has Run Its Course
Turkey - TRY/US$ Exchange Rate

However, we see limited upside following the 7.3% appreciation against the US dollar observed since the announcement of the emergency meeting. The political situation in Turkey remains highly uncertain, which will continue to weigh on foreign demand for lira-denominated assets. Meanwhile, rising US yields and Turkey's massive external deficits will act as a continuous source of downside pressure on the currency in the coming quarters.

Growth Outlook To Drag Down Equities

Our forecasts for Turkish real GDP growth (2.6% and 3.4% in 2014 and 2015 respectively) have been well below consensus since June 2013, and we now see risks weighted primarily to the downside. Consumer and business confidence are already suffering from political instability and financial market volatility. Meanwhile, a sharp slowdown in consumer and corporate credit growth on the back of monetary tightening will significantly cool a main engine of Turkish growth.

Limited Upside Potential
Turkey - Borsa Istanbul Equity Index

While the stabilisation of the lira and easing concerns of a balance of payments crisis has opened the potential for a short-term rally of Turkish equities, we see limited upside potential ( see, 'Europe Regional Equity Strategy', January 28) for the Borsa Istanbul equity index due to a rapidly deteriorating outlook for growth and political stability in 2014.

Significant Defeat For Erdogan

Embroiled in a corruption scandal and facing a major rift within his traditional support base ( see 'Major Implications Of AKP Rift' December 19), Prime Minister Recep Tayyip Erdogan has resorted to populist rhetoric, blaming political instability on an international conspiracy aimed at destabilising his government and raising domestic interest rates. Essentially, the central bank's tightening represents a significant blow to Erdogan, who may now be seen by his supporters as losing control of the situation and increasingly vulnerable. Furthermore, Erdogan's ruling Justice and Development Party (AKP) has staked its reputation, and derived a significant portion of its support base, from years of strong economic growth. Entering a busy election season in 2014 and 2015, slowing economic growth amidst an ongoing corruption scandal will make it even more difficult for the AKP to retain its single-party majority in parliament.

Read the full article

This article is tagged to:
Sector: Country Risk
Geography: Turkey
×

Enter your details to read the full article

By submitting this form you are acknowledging that you have read and understood our Privacy Policy.