The shift towards orthodox policymaking at Turkey’s central bank has supported a rally in the lira and, so long as the policy shift sticks (as seems increasingly likely) and the external environment remains supportive, we think that the currency’s appreciation has further to run. We forecast the lira to end this year at 7.00/$ which, if correct, would mark the currency’s first annual gain against the dollar since 2012.
- The shift towards orthodox policymaking at Turkey’s central bank has supported a rally in the lira and, so long as the policy shift sticks (as seems increasingly likely) and the external environment remains supportive, we think that the currency’s appreciation has further to run. We forecast the lira to end this year at 7.00/$ which, if correct, would mark the currency’s first annual gain against the dollar since 2012.
- 2020 was a particularly rocky year for Turkey, with the country teetering on the brink of a full-blown balance of payments crisis at numerous points. At its low point in early November, the Turkish lira stood at more than 8.50/$, down by more than 30% against the dollar year-to-date. (See Chart 1.)
- But the currency’s fortunes took a favourable turn in the final months of the year following an abrupt shift back to orthodox policymaking by the central bank. President Erdogan installed Naci Agbal as central bank governor in November and Mr. Agbal moved quickly to tighten monetary conditions, revert to the use of a single policy rate and signal a greater commitment to tackling Turkey’s inflation problem.
- We argued in an Update in November that, based on past experience, this shift in policy was likely to cause the lira to appreciate to around 7.25/$ within the subsequent three months. The lira briefly touched this level last week. It has given up some of its gains in recent days, but it is still 15% or so stronger than its low in early November. There remain significant downside risks facing the currency (more below), but we think that 2021 could be a rare positive year for the lira. This is for three key reasons.
- First, we are increasingly confident that the shift to orthodoxy is here to stay. Admittedly, President Erdogan doesn’t seem to have abandoned his unconventional views on economic policy. And we’ve warned before that, if the recovery struggles to gather momentum, inflation stays high and the lira comes under further downward pressure, Mr. Erdogan might feel that the orthodox approach is not working. Indeed, previous orthodox shifts in Turkey have often been abandoned quite quickly.
- Moves towards orthodoxy in the past have been forced upon policymakers by strains in the balance of payments and, while these strains have certainly played a role this time, the shift in policymaking appears to have also been a response to internal political pressure. Indeed, reports suggest that there had been growing concerns within the ruling AK Party that the president’s economic policymaking up to that point would reduce its popular support.
- Bringing inflation under control will take time and require the central bank to keep real interest rates high for a prolonged period. Even so, there is tangible evidence that the policy shift has improved investor sentiment towards Turkey. Hopes of an improvement in macro stability have supported a decline in Turkey’s risk premium – dollar bond spreads have already narrowed by 200bp since early November. (See Chart 2.) Long-term local currency bond yields have also dropped back. All of this will help to convince President Erdogan to stay the course.
- Meanwhile, the fact that the CBRT hiked interest rates again in December, by 200bp to 17.00%, reaffirmed that policymakers are keen to re-establish their inflation-fighting credentials. Mr. Agbal has pledged to improve the transparency and predictability of policymaking as well as to boost confidence in the lira and increase heavily-depleted foreign exchange reserves. We think that the CBRT will leave its benchmark one-week repo rate unchanged at 17.00% throughout most of this year.
- Second, the currency appears to be undervalued. The real effective exchange rate – that is, the trade-weighted exchange rate adjusted for inflation differentials with its main trading partners – is still around 4% below its long-run trend. (See Chart 3.) Of course, that might have been justified over the past year given the hit to Turkey’s current account position from the coronavirus crisis. (See Chart 4.)
- But, despite higher oil prices, we expect the current account deficit to narrow over the course of 2021. The global rollout of vaccines should result in a pick-up in external demand and, crucially for Turkey, a steady recovery in international tourism. At the same time, the recent tightening of monetary conditions and sharp slowdown in credit growth will take the steam out of import growth.
- Against this backdrop, it will be difficult to argue that, in real terms, the lira should be weaker than that implied by its long-run trend. In fact, a lower country risk premium would suggest that Turkey might be able to sustain a stronger real exchange rate than would otherwise be the case.
- Third, the external financing environment is likely to be supportive of the lira. Assuming that vaccine rollout progresses smoothly over the coming months, we think that global investor risk appetite will improve further and the US dollar will continue to weaken. Capital flows to emerging markets have already picked up strongly recently and there have been firm signs that, after many years of moving their money out of Turkey, the shift in policymaking has prompted foreign investors to start to return. (See Chart 5.)
- All told, we think that the recent rally in the lira may have a little further to run over the course of 2021 and expect it to end this year at around 7.00/$, an appreciation of around 7% from its current level. If correct, that would mark the first time since 2012 that the currency has appreciated against the dollar over the course of a calendar year. Our view stands in stark contrast to the consensus, which currently anticipates the lira falling back to around 8.40/$ by end-2021.
- There are a couple of key risks facing our lira forecast; one is relatively benign, the other less so. The first is that the central bank decides to intervene in the foreign exchange market to take advantage of an upturn in capital flows in order to rebuild its FX reserves. That would, all else equal, temper the lira’s appreciation, but provide a welcome improvement in the country’s balance sheet.
- The second is that there is a shock, most likely to come in the form of a ratcheting up of geopolitical tensions. While the current account position is likely to improve over the course of this year, Turkey’s large short-term external debts (see Chart 6) and low foreign exchange reserves leave the currency vulnerable to shocks. The threat of sanctions on Turkey is emanating from both the US and the EU and, if this turns into harsh action, the lira is likely to suffer a renewed leg down.
|Chart 1: Turkish Lira (vs. $, Inverted)||Chart 2: JP Morgan Turkey EMBI Index (bp)|
|Chart 3: Real Effective Exchange Rate (Jan. 10 = 100)||Chart 4: Current Account Balance (12m Sum, % of GDP)|
|Chart 5: Non-resident Holdings of Turkish Bonds and|
Government Domestic Debt Securities ($bn)
|Chart 6: Short-term External Debts|
(Remaining Maturity Basis)
|Sources: CEIC, Refinitiv, Capital Economics|
Jason Tuvey, Senior Emerging Markets Economist, email@example.com