Turkey - critical MPC meeting looming

The CBRT’s MPC meets again this week in what is shaping up to be a critical meeting on interest rates. 

Simsek’s reform team at the CBRT brought in after last year’s general election victory by the ruling AKP have gone further than many expected and hiked policy rates from just 8.5% to 45%. The hope was that this plus further tightening/cleaning up of the array of complex macro financial architecture introduced in the previous unorthodox regime, a $51 billion support package from the UAE, plus the credibility in the bank attributed to trusted reformers like Simsek (but also the Karahans, Akcay et al) would be enough. Initially there was a confidence boost with foreign institutional investors rewarding the team with portfolio inflows which helped the CBRT replenish much depleted FX reserves to the tune of $30 billion plus.

But a number of factors have worked against the reform team:

First, the lira pushed much weaker in the weeks after last year’s election creating additional inflation pass thru. Combined with an inflation busting 49% hike in the minimum wage in January a reflection of pre local election “lamb barrelling” this has seen inflation surprise to the upside - it looks likely to be higher for longer, approaching 70% at present and perhaps on track now to peak at 80%. This has left ex-post policy rates still heavily in negative territory and even challenging the outlook for ex ante positive real rates given where policy rates were pushed to.

Second, and linked above, TURKGB yields had prior been distorted by various macro prudential measures run by the prior unorthodox team, but around the 30% mark just did not suggest value/protection enough for foreign institutional investors given high inflation, a persistently high current account deficit and still depreciation pressure on the lira. Some foreign portfolio flows came but just not enough to create the virtuous cycle the reform team needed.

Third, and as noted, while the current account deficit has moderated, but it still stands at over $30 billion on an annualised basis - not helped by seasonals with energy imports during winter and tourism easing back. This creates a constant dollar bid.

Fourth, within the policy adjustment programme there have been inherent contradictions. The team has wanted to wind down the FX protected lira deposit scheme (KKM/DDM) and build/replenish FX reserves to get rid of key vulnerabilities while at the same time building resilience and buffers. But the latter have created new dollar demand which has played against the need for lira strength/real appreciation to help with the fight against inflation. Arguably policy rates, and lira deposit rates have just not been high enough to encourage enough maturing FX protected deposits back into lira.

Fifth, the last hike in policy rates and signalling of a long pause was probably a mistake - perhaps something was lost in translation with the HR flux at the CBRT with the forced exit of former governor Erkan. The market took the hike as the last and done and begun then pricing policy rate cuts to year end. Deposit rates dropped and again this undermined the de-dollarisation process.

Markets read the political tea leaves with local elections in March as precluding any further interest rate hikes - with the consensus still being that Simsek et al lacked sufficient independence from the presidency to do what it takes on the policy rate front. So rates at 45% was viewed as the ceiling, which the market tested with selling pressure on the lira.

Sixth, although UAE committed $51 billion to support the Erdogan administration soon after the May 23 elections the bulk of this was in long term investment commitments. Around $8.5 billion was promised in earthquake bonds but at a rate agreed of over 9%. Turkey delayed drawing down on this facility - thinking it could fund itself more cheaply on the Eurobond market. That appeared to be the case with Turkish credit spreads rallying in hard initially on optimism around Simsek’s appointment and an orthodox policy adjustment. Turkey 10 year paper has been trading in around 7%. But with hindsight it might have been better for the UAE earthquake bond facility to have been drawn to build additional FX buffers - that might still be the case, perhaps with the agreed rate negotiated lower.

Unfortunately all these factors have come together, with locals also expecting a repeat of the FX adjustment which followed the general election last May - despite messaging from the CBRT that they would like to see real appreciation to help in the fight against inflation. 

The CBRT has tightened macro prudential policies and that has pushed deposit rates higher but it is still seeing heavy selling pressure on the lira. It has met this with intervention but this is again depleting central bank reserves - which are lower than they were last May. 

In the end policy rate are just too low still.

Market sentiment seems to have turned against Turkey again and there needs to be an early confidence shock. It seems as though the only choice now is for the CBRT to provide a positive confidence shock - and I think they will move to hike policy rates by up to 500bps this week. The value of this hike will be multiplied as I think few in the market expect such a hike this side of local elections. Such a move will send a very clear message that Simsek and the CBRT have a strong mandate to fight inflation and are able to further tighten policy as needed - pushing back on the narrative that Erdogan has set red lines on rates and tying the central banks hands behind its back.

I think post election we will see further policy tightening - fiscal and monetary and as seasonal factors begin to bring improvement on the current account front this should help begin to improve sentiment and stabilise Turkish markets. Base effects should begin to help the inflation narrative in the second half of the year.

Actually recent changes at the CBRT (Simsek’s ability to ensure a smooth transition from Erkan to Karahan), the likely policy hike this week with Erdogan also talking about possible succession plans have acted to improve the position (political capital) of Simsek and his reform team. Post the local election I think we see Erdogan increasingly delegate areas of policy - and I think economic policy is one where his trust in Simsek et al will lead the way.