Turkey’s shift to orthodoxy and the impact so far

  • The shift in policymaking at Turkey’s central bank (CBRT) has supported a rally in local financial markets over the past few months and we think this has further to run. We now expect the Turkish lira to end this year at 6.25/$ (previously 7.00/$).
  • A shake-up of Turkey’s economic management team in November brought an abrupt shift towards more conservative monetary policymaking. Since then, the CBRT has tightened monetary conditions and reverted to the use of a single policy rate, rather than adjusting monetary conditions in an opaque way via the rate corridor. (See Chart 1.) The CBRT has also made a concerted effort to improve communications and recent comments have underlined that the inflation fight is being taken more seriously. (See here.)
  • President Erdogan hasn’t given up his unconventional views on economic policy but, even so, the developments have been encouraging. Previous moves to orthodoxy have been forced on policymakers by severe strains in the balance of payments. While these did play a role recently, more than anything it appears that President Erdogan has caved to pressure from within his own party over economic management. Meanwhile, there are signs that Turkey’s government is trying to repair strained relations with the US and EU which may go some way to reducing the threat of harsh sanctions. (See here.)
  • Investors seem to be confident that the move to orthodoxy will stick. We noted at the time of the CBRT’s policy shift that it boded well for Turkey’s financial markets (see here) and this has been borne out, typified by the strong performance of the lira. After reaching its low point in November, the lira has risen by more than 20% against the dollar (see Chart 2) and is, by some margin, the best performing EM currency since the start of 2021. (See Chart 3.) Earlier this week, the lira broke through our end-year forecast of 7.00/$.
  • The lira’s appreciation has been underpinned by a reduction in the risk premium that investors demand in exchange for holding Turkish assets. Indeed, dollar bond spreads – based on the JP Morgan EMBI Index – have narrowed by around 200bp since early November, which is much more than in most other major EMs. (See Charts 4 & 5.) The decline in risk premia has also supported a rally in Turkey’s local currency bonds, particularly at the longer end of the curve. (See Chart 6.)
  • That said, investors and analysts aren’t (yet) fully convinced that the central bank will manage to tackle the inflation problem. Indeed, market-based measures show that, while long-term inflation expectations have fallen since November, they remain elevated. (See Chart 7.) It’s a similar story among analysts who, in general, still expect inflation to be well above the CBRT’s target of 5% by 2025.
  • This is likely to reflect the fact that we are still in the early stages of the CBRT’s policy shift and it will take time for the central bank to bring down and anchor inflation expectations. Overall, though, investors’ views towards Turkey have improved more quickly than we had previously envisaged.
  • The factors that prompted us to turn more optimistic on Turkey remain in place. (See here.) And while there are still significant downside risks (after all, we’ve seen similar shifts before, only for the CBRT to subsequently lose investors’ faith), we think these are outweighed by the upside risks.
  • First, moves by the government to ease geopolitical tensions are encouraging and may continue to reduce Turkey’s risk premium. And second, we expect the central bank to keep monetary conditions tighter than most currently anticipate: our forecast is for the one-week repo rate to be left on hold throughout this year, whereas the consensus is for 375bp of rate cuts. If we’re right, that should help to reduce inflation and, in time, local currency bond yields, supporting the lira. Against this backdrop, we think that the lira’s rally has further to run and we now expect it to end this year at 6.25/$ (previously 7.00/$). (See Chart 8.)

Chart 1: CBRT Policy Rates & Average Cost of Funding (%)

Chart 2: Turkish Lira (vs. $, Inverted)

Chart 3: Change in Selected EM Currencies
(vs. $, 6th Nov. – 16th Feb, %)

Chart 4: JP Morgan Turkey EMBI Index (bp)

Chart 5: Change in EMBI Stripped Spread over US Treasuries (6th Nov. – 16th Feb, bp)

Chart 6: Local Currency Sovereign Bond Yields (%)

Chart 7: 5y/5y Breakeven Inflation Expectations (%)

Chart 8: Turkish Lira (vs. $, Inverted)

Sources: CEIC, Refinitiv, Capital Economics

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

Jason Tuvey Senior Emerging Markets Economist
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