Key takeaways
- Turkey is once again suffering from investors defiance toward its currency, as in 2018 and in March 2020, putting it apart from other emerging markets
- Turkey has adopted some unorthodox policies to support the Lira while essentially continuing its loose monetary policy, which fuelled a credit boom in 1H 2020
- A further weakening of the Turkish Lira against the dollar could be expected over the coming weeks, given the CBRT’s preference for maintaining the status quo.
- Eventually, a tightening of monetary policy should be implemented to stabilise the lira and to contain the risk of a full blown financial crisis, but this would contradict the President’s narrative and instructions delivered to the CBRT to support the economy. Hence, it remains to be seen how far the Central Bank is ready to lean against the political wind in Ankara.
Addendum: As of August, 7, 2020 the Central Bank announced that it would stop lending to Banks through its one week REPO window and move to the overnight rate which is higher by 150 bp. This move supported the Lira temporarily but it is still perceived insufficient compared to proper interest rate hikes.
Detailed analysis
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The Turkish lira has resumed its fall against the dollar over the last few days. The currency pair is now trading above 7 TRY per USD. Since the start of the year, the country’s central bank has spent in vain more than $100 billion of its foreign exchange reserves to defend the value of the currency so far this year, as can be seen on the chart below. FX reserves now stood at $45.8 billion dollars as of end June 2020 (Total official reserves stood at $86.3 billion dollars including $39 billion in gold). The Central Bank has used unorthodox financial engineering akin to the one used by the Banque du Liban, by engaging into cross-currency swaps with commercial banks in order to prop up its FX reserves, which it used on several occasions to defend the Lira’s “managed float”.
When the downward pressure on the Turkish currency started to intensify in March-April, coinciding with the outbreak of the coronavirus pandemic, Turkey’s Central Bank kept lowering its overnight lending rate, fuelling a credit boom (cf. blue dotted line) that served as a catalyst to the sharp depreciation of the Turkish Lira.
So far the surge in inflation related to the currency depreciation has been contained, as can be seen below. This is rather puzzling as it represents a break from the trend observed over the 2013-2019 period, especially during the 2018 market selloff which led to a self-reinforcing spiral between the falling currency and the jump in inflation, through the exchange rate pass-through. As already mentioned, this comes on the back of a significant monetary easing that has started in mid-2019 and that continued despite the build-up of pressures on the Lira. It remains to be seen wether this disconnect between inflation and the value of the Lira can be maintained. The softening inflation is partially related to the impact on GDP growth of the COVID-19 pandemic with an output gap in 2Q 2020 estimated at -6.4% by the CBRT (after -1.5% in 1Q 2020).
Contrary to the 2018 crisis episode, Turkey’s government bonds in lira have proven to be resilient to the fallout of the currency. This could be explained by the fact that most of the foreign holders of Turkey’s domestic bond in local currency have already exited the Turkish market two years ago. Foreign ownership of Turkey’s government bonds in TRY represent less than 5% of its outstanding stock. It remains one of the highest yielding sovereign securities among the G20 countries. But corrected for inflation, long term interest rates are deeply in negative territory at around -4%.
The question now is how far this may continue before the Central Bank decides to intervene by effectively tightening its monetary policy through the interest rate channel. So far, given the muted impact that Lira’s fall had on inflation this year and given the pressure from the government on the Central Bank to support the recovery, by keeping its rate at its current level, we should not see no radical changes. In its latest quarterly inflation report, the CBRT stated that “Credit growth and its composition [were] closely monitored for their effect on internal and external balance.” This means any policy tightening will not occur primarily through a hike in CBRT’s interest rate but through macro-prudential measures and other policies aiming at controlling the quantity of credit, not its price.
From what precedes, a further weakening of the Turkish Lira against the dollar can be expected over the coming weeks, unless an acceleration of the currency sell-off eventually triggers a reaction from the CBRT.
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