Lira to fall further as policy response fails to appease

  • The Turkish lira has continued to weaken in recent weeks and, with the response by policymakers likely to fail to placate investors, we now expect the currency to fall to as low as 9.25/$ by the end of next year. What’s more, the risks lie firmly towards more abrupt falls in the lira in the near-term that ultimately force the central bank into aggressive hikes to policy rates.
  • The Turkish lira has steadily weakened since the middle of July after the central bank abandoned the de facto peg to the dollar, breaking through our year-end forecast of 7.50/$ and reaching a record low of 7.68/$. (See Chart 1.) The currency is now down by more than 22% since the start of this year, making it one of the worst performing across the emerging world.
  • Pressure on the lira has come against the backdrop of Turkey’s large macro vulnerabilities. The current account deficit has widened. (See Chart 2.) Short-term external debts remain large, at around 24% of GDP. (See Chart 3.) And previous efforts to defend the lira have severely depleted Turkey’s foreign exchange reserves. (See Chart 4.) The CBRT’s FX reserve position looks even worse on a net basis and once foreign currency swaps with commercial banks are taken into account.
  • All of this leaves Turkey vulnerable to a deterioration in investor risk appetite. The latest slide in the currency has come alongside worsening global risk appetite as well as rising tensions with the EU related to Turkey’s drilling for oil and gas in the East Mediterranean. EU leaders are due to meet later this week to discuss possible sanctions on Turkey.
  • On some measures, the lira does now appear to be undervalued. The real effective exchange rate (that is, the trade-weighted exchange rate adjusted for inflation differentials with its trading partners) is almost 12% below its long-run trend, which is the largest difference since the 2018 currency crisis. (See Chart 5.) It’s important to note that, after hitting its low point in 2018, the real exchange rate returned to its trend (in nominal terms, the lira strengthened by some 30% against the dollar).
  • But there are some key differences between now and 2018. For one, there are reasons to think that Turkey’s sustainable real exchange rate, and the fair value of the lira, has shifted down in recent months. After all, the coronavirus crisis has dealt a significant and long-lasting blow to Turkey’s tourism sector and thus its services exports and current account position. A weaker lira forms part of the adjustment.
  • What’s more, the policy response this time has been very different to that in 2018. Back then, pressure on the lira eased after the central bank signalled, and delivered, aggressive interest rate hikes. The CBRT also overhauled its policy framework and declared that it would stick to a single policy rate. While we were always sceptical of this, it seemed to do enough to convince investors that the CBRT was more serious about rebuilding its credibility and tackling the country’s inflation problem.
  • This time, though, the central bank’s response has reinforced concerns about the policymaking environment in Turkey. Admittedly, the CBRT has tightened monetary conditions in recent weeks, with the average cost of funding rising by more than 325bp, to 10.61%, since mid-July. (See Chart 6.) And it seems increasingly likely that the CBRT will shift all funding for commercial banks to the late liquidity window, which marks the top of the rate corridor with an interest rate of 11.25%.
  • But there are no clear signs that the CBRT is willing to tackle the inflation problem head-on. The central bank seems loath to hike official policy rates due to pressure from President Erdogan. Even if nominal interest rates hit the top of the corridor, real interest rates will remain negative – headline inflation stood at 11.8% y/y in August. In 2018, real rates were pushed into positive territory. Policymakers’ shift in focus towards maintaining a “competitive” lira suggests that they are now more willing to let the lira weaken.
  • All told, then, we think the real exchange rate will remain below its historic trend. And given the much higher rates of inflation in Turkey than in its trading partners, the nominal exchange rate will need to fall even further to maintain external competitiveness. We now expect the lira to fall to 8.00/$ by the end of this year and to 9.25/$ by end-2021 (previously 7.50/$ and 8.25/$ respectively).
  • The risks are clearly skewed towards even larger and more abrupt falls in the lira in the near-term as well as aggressive hikes to policy rates. We warned in a recent Focus that the chances of another currency crisis have increased markedly. In May, only some last-minute financing from Qatar prevented such an outcome.
  • One possible trigger would be if the EU moves quickly and imposes harsh sanctions on Turkey. EU officials have reportedly floated the idea of pulling out of the customs unions with Turkey, which would do severe damage to Turkey’s economic prospects. There is also the lingering threat that the US imposes measures against Turkey, particularly if the country deploys its recent purchase of Russian defence equipment.

Chart 1: Turkish Lira (vs. $, Inverted)

Chart 2: Current Account Balance

Chart 3: Short-term External Debt
(Remaining Maturity Basis)

Chart 4: Foreign Exchange Reserves

Chart 5: Real Effective Exchange Rate

Chart 6: CBRT Policy Rates & Avg. Cost of Funding (%)

Sources: CEIC, Refinitiv, CBRT, Capital Economics


Jason Tuvey, Senior Emerging Markets Economist, jason.tuvey@capitaleconomics.com

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