Rate Hikes Wont Halt Lira Slide

Short-Term Outlook

Facing a crisis of confidence and destabilising pace of lira depreciation as a domestic political crisis unfolded ( see 'Major Implications Of AKP Rift', December 19) amidst waning global demand for risky emerging market assets, the Central Bank of Turkey (CBRT) was forced to call an extraordinary monetary policy committee meeting and aggressively tighten on January 28, raising its benchmark policy rate by 550 basis points. In our view, this was sufficient to stabilise the lira and restore investor confidence over the short term. However, while acknowledging the potential for further consolidation in the coming months, we expect the underlying depreciatory trend to remain in place ( see chart), and forecast the lira to reach TRY2.3000/US$ by end-2014, from TRY2.1850/US$ at the time of writing.

Core View

Subdued Inflows To Prevent Appreciation
Turkey - TRY/US$ Exchange Rate And Balance of Financial Account Minus Current Account, 6mma
BMI Turkey Currency Forecast
Spot 2014 2015
TRY/US$, ave 2.1850 2.2450 2.3400
TRY/EUR, ave 2.9985 2.8750 2.8560
Policy Rate, % eop 10.0 10.5 10.0
Source: Bloomberg, BMI; Date: February 12, 2014
Underlying Trend To Remain Intact
Turkey - TRY/US$ Exchange Rate

Short-Term Outlook

Facing a crisis of confidence and destabilising pace of lira depreciation as a domestic political crisis unfolded ( see 'Major Implications Of AKP Rift', December 19) amidst waning global demand for risky emerging market assets, the Central Bank of Turkey (CBRT) was forced to call an extraordinary monetary policy committee meeting and aggressively tighten on January 28, raising its benchmark policy rate by 550 basis points. In our view, this was sufficient to stabilise the lira and restore investor confidence over the short term. However, while acknowledging the potential for further consolidation in the coming months, we expect the underlying depreciatory trend to remain in place ( see chart), and forecast the lira to reach TRY2.3000/US$ by end-2014, from TRY2.1850/US$ at the time of writing.

Core View

Accelerating growth in the US and Europe, and the gradual winding down of ultra-loose developed state monetary policy in the coming years, will usher in a period of slower growth for many emerging market economies as global liquidity conditions tighten. Although Turkey was a main beneficiary of capital inflows over the previous decade, this contributed to mounting foreign liabilities and widening external deficits that have increased the risk profile of lira-denominated assets and made it among the most vulnerable countries to slowing growth on the back of less abundant and more expensive foreign financing. This dynamic will be a main driver of the lira's trajectory in the coming years, which we expect to remain on a steady depreciatory path.

Total capital inflows into Turkey are set to remain well below previous years' levels, eliminating what we see as the only real driver of potential lira strength. Even during previous periods of robust financial account inflows, the lira has shown a tendency to stabilise, as opposed to strengthen ( see chart). The composition of Turkey's current account deficit financing, weighted heavily towards portfolio and other investment with a minimal contribution of long-term foreign direct investment (FDI), increases volatility in the financial account and leaves the lira prone to bouts of weakness.

Subdued Inflows To Prevent Appreciation
Turkey - TRY/US$ Exchange Rate And Balance of Financial Account Minus Current Account, 6mma

Turkey's current account deficit, which we estimate to have reached 7.3% of GDP in 2013, will thus act as a continuous source of pressure on the currency in the absence of large financial account surpluses. While credit growth and strong domestic demand played a hand in deficit widening, Turkey's reliance on imported energy is the primary cause of the country's massive external financing needs. As such, even a pronounced slowdown in economic activity in 2014 will be unable to quickly narrow the deficit, which we expect to remain uncomfortably high over a multi-year time horizon.

While Turkey was already set to experience a slowdown in capital account inflows due to glaring macroeconomic imbalances and waning investor risk appetite, we believe that a mounting political risk profile will reinforce this trend, especially in regards to badly needed FDI. Furthermore, the credibility of the CBRT has been damaged by what is perceived as a strong pro-growth bias that originates at the highest levels of government, calling into question its independence.

Regardless of whether or not the CBRT is under government influence or not, since H113 it has in fact shown a greater tolerance for FX weakness. As such, in the coming years we expect the bank to maintain the policy rate at a level which guarantees external financing needs, but is insufficient to provide the type of carry appeal necessary to see sustained FX strength as rising US yields exert continuous pressure on the attractiveness of lira denominated assets.

Risks To Outlook

Due to an uncertain and volatile political climate that has the potential to weigh heavily on investor confidence, we see both short and medium-term risks as weighted primarily to the downside. As evidenced by the Gezi Park protests in the summer of 2013 and the recent graft investigation, bouts of political instability can greatly accelerate selling pressures on the lira. We expect the political situation to remain volatile in the run up to parliamentary elections in 2015, implying significant risk of further destabilising developments.

Furthermore, the trajectory of developed state growth, in particular in the US, will continue to impact demand for the lira. Although the recent rate hike has bolstered the appeal of Turkish assets, a rapid rise in US yields could quickly reverse this sentiment in the coming months.

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