Emerging Markets | Europe | FX | Monetary Policy & Inflation
Turkish policymakers have returned to the populist policies of yesteryear that pushed the country to the brink in 2018, when inflation surged to 25% and the currency tanked 40%. The ongoing deluge of monetary injections amid negative real rates will cause inflation to spike again, current account deficit to deteriorate further, and currency to fall to new lows:
• The Turkish central bank (CBRT) has slashed policy rates massively over the past year, from 24% to 8.25%. Since inflation is still in the double digits, the real interest rate has slid to a negative 2%, making borrowing very cheap. Moreover, CBRT is also providing copious amount of liquidity to the commercial banks. That, coupled with various newly introduced lending schemes and regulations, has incentivized banks to open the loan spigot. This is manifested in surging bank lending: lira-denominated loans are growing at a decade high rate of 45%, at a time when the pandemic has brought economic activity to a standstill (Chart 1).
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Turkish policymakers have returned to the populist policies of yesteryear that pushed the country to the brink in 2018, when inflation surged to 25% and the currency tanked 40%. The ongoing deluge of monetary injections amid negative real rates will cause inflation to spike again, current account deficit to deteriorate further, and currency to fall to new lows:
- The Turkish central bank (CBRT) has slashed policy rates massively over the past year, from 24% to 8.25%. Since inflation is still in the double digits, the real interest rate has slid to a negative 2%, making borrowing very cheap. Moreover, CBRT is also providing copious amount of liquidity to the commercial banks.
That, coupled with various newly introduced lending schemes and regulations, has incentivized banks to open the loan spigot. This is manifested in surging bank lending: lira-denominated loans are growing at a decade high rate of 45%, at a time when the pandemic has brought economic activity to a standstill (Chart 1).
- Fiscal expenditures have also ballooned, aided by CBRT and the commercial banks’ government bond buying binge. Consistent with all these, money supply in the Turkish economy has skyrocketed. Narrow money (M1) is rising at 90% year-over-year; the broad money (M3) is growing at 40% (Chart 2).
- Such a surge in new money creation has always fuelled inflation in the past, and this time will likely be no different. Chart 3 shows that the inflationary pressure in the Turkish economy remains quite entrenched and is on a structural uptrend. The ongoing ultra-loose policy will lead to another spike in the price pressures.
Worsening matters, the onset of covid-19 has decimated Turkish balance of payment. Since March this year, tourist arrivals are down by over 95% from the same period last year. Exports are faring poorly also. Simultaneously, ultra-loose fiscal and monetary policies mean imports have not fallen in tandem. The outcome is that the trade and current account deficits keep deteriorating (Chart 4). This is weighing on the currency.
One way to plug the current account deficit could have been international capital inflows. But unorthodox policies and very low/negative real rates have driven away foreign investors. This has made the currency even more vulnerable. Indeed, history shows that periods of negative real rates in Turkey are usually associated with a weaker lira.
Meagre capital inflows means that Turkey is forced to finance its current account deficit by drawing down its foreign reserves. But they are falling at an alarming rate: gross reserves are down from $80 billion at the beginning of the year to $50 billion now. Notably, this ‘gross reserves’ figure includes borrowed funds, swap lines, and foreign currency deposits belonging to commercial banks. Once deducted, the ‘net’ foreign reserves of CBRT are actually negative! To put that into perspective, the country’s foreign debt obligations over the next 12 months stand at $170 billion, according to the Financial Times.
The upshot is that, unless Covid-19 subsides and tourism and exports pick up meaningfully in the next few months, CBRT is in no position to defend the currency for much longer. Rising inflation and a falling currency mean even local residents could abandon the lira at some point. There are already signs of this: real estate prices have begun to soar amid an economic recession – an indication that residents are beginning to pile up on real assets, such as property, and getting rid of lira.
The alternative for the policymakers is to pursue a much tighter policy. That will help save the currency, but at the cost of further economic pain. Higher interest rates, slower bank loans and/or lower fiscal expenditures would mean further retrenchment in the economic activity. However, given the revealed preferences of the Turkish authorities, odds are that Turkish policy will remain highly accommodative in the foreseeable future; and it will be the lira that will be let go at the end. Foreign investors, therefore, should brace for further downside in Turkish currency.
Rajeeb is an Emerging Markets macro professional with 25 years experience in various roles as bankers, macro strategists and buy-side portfolio managers. He spent ten years at the independent macro research firm, BCA Research, where he launched and ran the Frontier Markets strategy service as well. Rajeeb has an MBA from HEC Montreal, and he is a CFA charter-holder.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)