Turkey: reviving the Lira

The skies were dark over Istanbul on Friday, but for the Turkish central bank the clouds have lifted. After a titanic struggle to defend the Turkish lira – which involved spending some $15bn ofreserves and increasing effective interest rates from 5.75 per cent to around 12 per cent – the pressure is off, at least for now.

The lira has strengthened from its low point last month of about TL1.92  to the dollar, trading at around TL1.82 on Friday – and interest rates have come down.

It is hard to give a precise figure for current rates, precisely because the bank uses what it calls an interest rate corridor, which allows it to move rates up and down on a daily basis by rationing the supply of cheaper weekly loans. But analysts say the effective rate is down to about 7.5 per cent compared to those earlier levels of 12 per cent.

The bank has even started lending at the 5.75 per cent benchmark rate again.

One big factor in lifting the sense of siege is improved sentiment about emerging market risk across the world; another has been the central bank’s own steps.

Despite many calls from abroad for a simpler, more easily comprehensible policy, analysts such as Nilufer Sezgin at Ekspres Invest in Istanbul say the bank has generally been sure-footed and that volatile times require all the flexibility the interest rate
corridor can provide.

But is it time to relax? Inflation is above 10 per cent and second order inflationary effects from the lira’s slide last year could kick in. Net central bank reserves are less than $50bn when items such as liabilities to the International Monetary Fund and commercial banks’
deposits are excluded. And the current account – probably the economy’s greatest weak point – remains at about 10 per cent of gross domestic product, despite recent indications it is inching down.

So while the bank may enjoy a certain feeling of satisfaction, it shouldn’t unfurl a mission accomplished banner any time soon.

Sezgin adds: “If we take the beginning of the emerging market optimism that  started on January 6 as a reference, the Turkish lira appears to be a slight underperformer, despite $50m foreign exchange sales every day. Underperformance could have been avoided partly if the central bank had not fully eliminated the additional tightening by reducing the funding cost by 450 basis points back to 7.5 per cent… The central bank may again have to overshoot in terms of tightening should sentiment sour.”

Indeed there may be other reasons to question the basis for the bank’s recent decision to relax its stance. The bank is officially independent, but the government is a vigorous proponent of lower interest rates.

How vigorous? In a recent speech, Recep Tayyip Erdogan, Turkey’s powerful prime minister, vowed to fight for lower rates in the face of what he called “the interest rate lobby”, which he said was on the attack.

He called for the gap between market interest rates and the benchmark 5.75 per cent to be closed closed, arguing that high interest rates cause high inflation. “The lower we can bring down market rates, the less inflation will be,” he said.

The prime minister’s arguments aren’t exactly what the economic texbooks say. But in coming weeks, Turkey – the central bank in particular – may put his theory to the test. For Turkey’s economy, much will depend on the outcome.