Fears of Turkish currency crisis loom

Turkish central bank (CBRT) efforts to stabilize the lira by backdoor tightening have proven ineffective as the currency hit a series of record low levels versus the dollar and the euro in recent months.

This week it slid to 8.5400 versus the dollar and just above 10 versus the euro last Tuesday. The depreciation of the currency is putting pressure on the Turkish central bank to deliver aggressive policy rate hikes to break this momentum. The bank will hold its next monetary policy committee meeting on November 19.

Opposition to rate hikes

The central bank is faced with a dilemma using its most effective policy tool. Governor Murat Uysal said at the central bank's quarterly inflation briefing on October 28 that the bank can take all the necessary steps, "including on policy interest rates" raising expectations for a rate hike at the upcoming meeting.

However recent comments from politicians limited the central bank's room for maneuver. Turkish President Recep Tayyip Erdogan said Turkey was waging war against a "devil's triangle" of interest rates, inflation and exchange rates. Erdogan has repeatedly railed against raising interest rates. He advocates an unorthodox theory that high interest rates lead to high inflation.

Turkey's Finance Minister and Erdogan's son-in-law, Berat Albayrak, said "the volatility in exchange rates are not above expectations" and an intervention was not planned unless there was an extraordinary situation, Turkish media reported citing a meeting between Albayrak and ruling AKP lawmakers.

Albayrak reportedly said the volatility in the currency was caused by uncertainties regarding the US presidential election and coronavirus pandemic. Higher interest rates would hurt employment, he said, adding he expected the lira to stabilize after a while.

"Albayrak basically confirmed that the CBRT has gone out on a limb, without the blessing of political leaders, to tighten monetary policy. The market will look through such tightening even more now, and the exchange rate is likely to soon come under pressure", Tatha Ghose, a senior economist at Commerzbank, said in a report for the lender.

'Symbolic of political pressure'

Over the years the central bank has resorted to a tightening policy by raising borrowing costs and adjusting liquidity, without resorting to an outright policy rate hike.

The central bank has tightened policy in recent months as the lira continued to slide. It raised its benchmark rate by 200 basis points to 10.25% in September. The decision was welcomed by investors. The central bank has since tightened policy further by limiting funding at its key one-week repo rate, forcing lenders to use costlier overnight lending facilities.

These tightening steps have raised expectations for another rate hike at last month's monetary policy meeting, but the bank unexpectedly put its policy rate on hold and raised the upper bound of its interest rate corridor, stunning investors and extending the lira's decline.

"Investors have never looked favorably upon the CBRT's use of the rate 'corridor' as it is seen as symbolic of the political pressure on the institution," Jason Tuvey, a senior emerging market economist at Capital Economics, remarked in a report.

The lira has hit a series of record lows against hard currencies since August. It has lost more than 30% of its value this year mostly on concerns over depleted currency reserves and costly foreign currency interventions as well as diplomatic tensions.

Investors are worried about the risk of rising inflation and even a currency crisis. The central bank raised its inflation forecast for the end of this year to 12.1% at the end of October, from a previous forecast of 8.9%.

History to repeat itself?

"Political pressure on the CBRT means that there is high probability that it fails to do enough to soothe investors and stays behind the curve. The experience from 2018 is that this would trigger even more abrupt falls in the lira and another currency crisis ensues," said Capital Economics' Jason Tuvey.

The slump in the currency is a reminiscent of the meltdown two years ago which forced the central bank to hike its benchmark rate by 625 basis points to stem the lira rout and ease investor concerns about President Erdogan's influence on monetary policy.

Some analysts say the central bank may have to take action before its meeting next month if losses in the lira aren't contained. It wouldn't be the first time. The central bank raised interest rates by 300 basis points in an emergency meeting in May 2018 and more than doubled them at an emergency meeting in January 2014 in attempts to stop similar sell-offs. The circumstances were also similar with mounting geopolitical risks and concern over monetary policy.

"At the moment they are trying sleuth tightening, knowing they need to hike rates but trying to hide what they are doing from Erdogan and the population," Timothy Ash, a strategist at BlueBay Asset Management, told DW. "I think they know that they will have to hike the base rate on November 19 but are trying to survive until then without a proper currency crisis. It's inevitable they will have to hike in a repeat of 2018."

Turkey's consumer price inflation rose to 11.89% year on year in October, well above the official inflation target of 5%, maintaining pressure for tight monetary policy. The market is on edge given rising geopolitical tensions over energy exploration in the Mediterranean as well as concerns over the outcome of the US presidential election and its implications for Turkey-US relations.