This was evident by the overnight rate quickly normalising on Wednesday. However, with the normalisation came fresh selling pressure on the lira, which found itself breaking the 7.00 level that evening. The breach of the psychological level came despite reports that Turkish state banks sold more than $1bn to try and stem the effects of heightened demand for foreign currency that day. The lira continued to slide for the remainder of the week, hitting fresh all-time lows both Thursday and Friday. In response, Turkish officials vowed to use all measures to curb excessive volatility in the currency, but this was an ambiguous statement with little clarity for markets. Was it a declaration of potentially higher rates by the TCMB in the coming weeks? Or perhaps a further reduction in offshore liquidity conditions to prevent further currency depreciation? Or will the Erdogan administration give up the ghost and let the 7.00 level slide? In our opinion, it is likely to be a mixture of all of the above, with an interest rate hike potentially needed before the next scheduled meeting on August 20th. We see interest rates being hiked 100bps at the central banks next meeting.
How did it get to this point?
Prior to the outbreak of the global pandemic, the TCMB had been on a rapid easing cycle after hiking the repo rate to 24% in the aftermath of the 2018 currency crisis. The disinflationary channel created by the effects of a more stable lira and higher interest rates gave the central bank the space to lower rates aggressively, with the repo rate cut by 1575bps in little under 12-months. In markets.Then the pandemic hit. Emerging markets experienced capital outflows reminiscent of the 2008/09 financial crisis and the Turkish lira quickly reached a fresh low of 7.269 against the dollar. Intervening in markets, the efforts by State banks quickly brought the lira back below the 7.00 level and the new implicit managed float style system all but killed volatility in the USDTRY cross. While authorities were quick to dispel any suggestion of capital controls in Turkey’s markets, the extreme intervention in FX markets along with the prolonged liquidity shortage in offshore markets suggests otherwise. The liquidity shortages in offshore markets led to multiple spikes in implied rates used for hedging options, which resulted in widespread settlement failures.
This led to major banks such as Citi, UBS and BNP Paribas being banned from accessing local lenders, which meant further restrictions to Turkey’s capital markets for foreign investors. In response to the viral outbreak, cheap credit was issued in Turkey. Domestic loan growth rose to levels not seen since 2018, resulting in a deterioration in the current account and further pressure on the lira. Additionally, the TCMB’s easing cycle ground to a halt, with the central bank cutting 250bps since March but holding rates at 8.25% at the last two meetings in June and July. Real rates remain in negative territory, which isn’t helping the trajectory of inflation, especially now a weaker lira is in play.
With negative real rates and cheap credit resulting in a current account deficit re-emerging, Turkish monetary policy was walking a fine line while still defending its politically sensitive currency. Reserves began to drain as if the market had just pulled the plug on the lira. Foreign currency reserves fell by $34.6bn despite strong domestic debt issuance, while Goldman Sachs estimates that year-to-date interventions come in around $65bn. This highlights the length to which monetary authorities buffered market forces. With reserves rapidly depleting, credit growth still elevated but set to taper according to recent central bank communications, and the tourism industry in a state of tatters, it is arguably the time for the lira to weaken above the 7.00 level in the medium-term and higher interest rates.
What next for the lira?
This is where things get tricky. The political consequences of both a higher interest rate and a weaker currency are severe for President Erdogan. After losing a large share of his base in last year’s election, notably in key metropolitan hubs such as Istanbul, the President will be keen to control the latest events in the most limited way possible. Reserves have basically hit rock bottom, with the current data being propped up by swap agreements with local banks as some $200m of household wealth is held in foreign currency in Turkey. So this leaves Turkey with three options, all of which have negative consequences for the economy.
Option 1: Continue to drain offshore liquidity to stabilise the currency. We see this as the likeliest near-term solution in order to prevent increasing short-positions building up. Despite the overnight rate returning from 1000% to normal levels of around 6%, hedging costs further out remain elevated. For example, on Friday of last week, the implied yield on 1-week and 3-month forwards was 28.245% and 22.15% respectively. This isn’t just driven by liquidity measures, but also expectations of rising interest rates. However, as seen in the aftermath of 2018, this cripples foreign investor sentiment, which will ultimately cap the longer-term recovery of the lira once economic conditions stabilise.
Option 2: Let the lira continue to slide while maintaining limited access for capital markets. With the treasure chest of reserves practically empty after discounting the impact of swap lines with domestic banks, Turkish officials could hold the interest rate at 8.25% and allow the lira to depreciate and clear the pressure from the current account deficit as the credit stimulus winds down. While this could limit the likelihood of higher interest rates and lower growth, it exposes one of Turkey’s largest financial vulnerabilities. A substantial share of corporate debt is issued in foreign currency, about $289bn to be exact, while $169.5bn of Eurobonds are to be rolled over in the next 12-months. A weaker currency would not only increase the cost of servicing, but also refinancing debt.
Option 3: Higher interest rates. While this option prolongs the economic recovery and could further erode Erdogan’s popularity, it is arguably the most effective means of controlling the slide in the currency. Raising rates in line with the expected inflation uptick to keep real rates neutral is a likely option. However, given the political opposition to higher interest rates we expect Turkey’s real rate to remain negative this year unless conditions deteriorate substantially. Governor Uysal must tread this path carefully though as such a route eventually led to the demise of his predecessor, Murat Cetinkaya, back in July 2019.
The drawbacks of all of the options above means a blended response is the likeliest option from Turkish officials. We see the cost of taking short positions in the lira rising initially as offshore liquidity thins even further, while a continued depreciation in the lira takes place. All the while, credit stimulus will be wound down. If conditions allow, interest rates will remain on hold until the TCMB’s next meeting on August 20th, however risks are tilted towards an earlier announcement. We expect the central bank to front-load their monetary tightening to restore confidence in markets with a rate hike of around 100bps this month.