Comment: Turkish lira holders demand higher rates ahead of central bank meeting

By Ipek Ozkardeskaya, London Capital Group.

The Turkish lira’s aggressive sell-off marked the beginning of 2017.

It all started on Saturday 6 January. Turkey’s ruling AK Party submitted a bill to pass a constitutional referendum, which aimed to dissolute the actual parliamentary regime and strengthen the power of President Recep Tayyip Erdogan at the heart of the country.

On a historical note, President Erdogan was a former member of the AK Party, undoubtedly one of the most influential members who played a major role in keeping the AKP in power from 2003 to today. Erdogan has served as Prime Minister from 2003 to 2014, and as President from 2014 until now.

In a tense and chaotic environment, the Turkish Parliament collected enough votes to approve a series of clauses that pave the way toward the constitutional referendum that could take place as early as April 2017.

As a consequence, Turkey is facing a severe threat to its parliamentary regime. The country is heading into the most critical period of its modern history. The last time Turkey was subject to a regime change was 1923, the collapse of the Ottoman Empire.

Quick summary of 2016

Since the beginning of 2016, the lira has lost up to 35% against the US dollar and up to 32% against the single currency.

This period was marked by the reshuffling of the Central Bank of Turkey’s (CBT) Monetary Policy Committee to a significantly more dovish team appointed by President Recep Tayyip Erdogan.

The new MPC team cut the overnight lending rate by 250 basis points, from 10.75% to 8.25%.

Over the same period, the recovery in oil prices sent the barrel of Brent crude oil from $40 to nearly $60.

As an energy dependent country, Turkey’s cost in oil and commodities rose significantly due to more expensive global energy prices, topped by a significant appreciation in the US dollar.

Hence, to many citizens’ surprise, headline inflation was announced down from 8.8% in July to 7.0% in November. In between, Turkey experienced a failed coup attempt on 15 July, which ramped up political risk in the country.

The war in Syria continued and even spilled over to Eastern Turkey. Terrorist attacks became more frequent, foreign tourist arrivals dropped up to 40% in summer.

In his desperation, President Erdogan was brought to present his excuses to Russian President Vladimir Putin, for the downed Russian drone.

On the back of the variety of challenges that the country was facing, leading global rating agencies as Fitch and S&P downgraded Turkey’s credit note to junk.

Regular capital inflows drop sharply in September and December

From the capital flow perspective, Turkey benefited from regular capital inflows in the first half of 2016. According to the cross-border flow data, the outflows haven’t started immediately following the 15 July failed coup attempt. However, heavy capital outflows hit the country’s balance sheet in September and in December.

Whilst the opacity in Turkey’s current account balance has often been an issue for analysts, many of them think that the improvement in the country’s balance of payment could be at a reversal point.

In fact, the sharp fall in tourist revenues, political and geopolitical unrest, combined with the sizeable depreciation in the lira and the global recovery in energy prices, hint at a reversal and perhaps an inflection in Turkey’s balance sheet dynamics.

In this context, the medium to long-term trend in the lira remains comfortably negative.

A rate hike is critical and necessary

The dollar-lira (USDTRY) rate hit the record of 3.94 on January 10th, as the euro-lira (EURTRY) surged to 4.17 for the first time since the launch of the New Turkish Lira.

As the Turkish lira insistently renews its record lows against the US dollar and the euro, one of the most frequently asked question is how far could the sell-off in the lira continue?

The answer is until a worthy intervention from the central bank, because the sell-off is undeniably aggravated by the CBT’s meagre reaction to the free-falling lira.

In fact, on 10 January, the CBT attempted to sell $1.5bn to curb the sell-off in liras, yet the selling camp was apparently far larger than this.

The FX intervention was merely perceived in the market price, even less as some market participants ran the rumour that the CBT did not even sell the US dollars as promised.

Either way, the CBT finally had to put the $1.5bn as promised on the table.

However, as the market was craving for a rate intervention in order to cover the rising economic and political risks of holding the lira, the FX selling attempt was an unnecessary, yet costly interpolation.

The sell-off in the Turkish lira couldn’t be avoided.

Finally on 12 January, the CBT came out with a creative solution: it didn’t provide any funding to the market through its weekly repurchase auction at the rate of 8%.

Hence, banks were left with the late borrowing option at the rate of 10%.

The sharp liquidity tightening revived speculation that the Central Bank would finally act on rates, despite the very well-known pressure to keep the rates at the lowest possible levels by President Erdogan himself.

Is this good news? From a short-term perspective, the intervention helped curbing the immediate selling pressures and the lira consolidated losses over the week that followed the heavy squeeze.

In term, we are worried that the 12 January unconventional action may open a new era for the Central Bank of Turkey; an era of increased opacity, unscheduled, impulsive and anonymous interventions to cool-off the wild downside pressures on its currency.

The credibility of the CBT has taken a dreadful hit and avoiding to face the reality by acting secretly would only weaken investors’ confidence, even regarding its unpredictable amendments to its often inappropriate strategy.

Either way, investors will be demanding for a sizeable rate hike on the monetary policy meeting on Tuesday 24 January, even more as Fitch is expected to lower its outlook on 28 January.

Erdogan’s officials have already hinted at a rate action.

Analysts expect Turkey’s overnight lending rate to be raised by 75 basis points to 9.25%, the benchmark repurchases rate by 50 basis points to 8.50% and the overnight borrowing rate by 25 basis points to 7.50%. The late lending rate should also be readjusted higher, if it becomes the bank’s new tool in emergency situations.

Ipek Ozkardeskaya is a senior market analyst at London Capital Group.