An interest rate hike from 8.5% to 15% would rank as shock and awe in most places. In Turkey, with inflation galloping at 40% annually, it landed as a disappointing baby step.
The lira, whose value has cratered by 80% against the dollar over the past five years, lost another 6% following the central bank’s decision on June 22. “This was definitely at the very low range of expectations,” says Blaise Antin, head of sovereign research at TCW.
Turkey’s Eurobonds still look attractive at yields around 9%, though.
The rates move was the de facto public debut of the hoped-for economic dream team that president Recep Erdogan unexpectedly appointed after winning re-election in May. Mehmet Simsek, a respected economist with long experience at Bank of America, returned as finance minister. Hafize Erkan, who worked at
Goldman Sachs
for a decade, took over the central bank.
They’ve got their work cut out for them. Turkey’s government deficit is near 8% of gross domestic product after a pre-election spending splurge. Current account deficits run around 4% of GDP. Net foreign reserves—cash balance minus loans from other central banks through swap agreements—are deep into negative territory.
“The economy is fundamentally out of whack,” says Edward Al-Hussainy, senior currency analyst at Columbia Threadneedle Investments. “They need interest rates three times where they just moved them and much smaller deficits on the fiscal side.”
The cost of such therapy, of course, would be a severe growth shock, likely lasting years—especially without International Monetary Fund assistance, which Erdogan has ruled out on national pride grounds.
The veteran leader, who just secured five more years in power, could oversee such a painful transition. Investors doubt that he will. “Prior pivots to orthodoxy have been thrown out the window after they achieved some success,” says Aaron Hurd, senior currency portfolio manager at State Street Global Advisors. “It will take even longer to regain trust this time.”
Fiscal policy looks to be actively undermining monetary tightening for the moment. The government just hiked the minimum wage by a third. Half the country’s employees are indexed to that move, Antin estimates. Erdogan loosened pension requirements during the campaign, entitling some two million Turks to earlier retirement at state expense, he adds.
Simsek and Erkan have yet to install allies below them at the central bank and state banks, which have been the engine of uncontrolled credit in Turkey. All Erkan’s lieutenants on the monetary policy committee remain holdovers from her hapless predecessor, Sahap Kavcioglu. He himself has moved over to head banking regulator BRSA, hardly a confidence builder.
The underwhelming rate hike signals a policy of “extreme gradualism,” says Murat Ucer, an Istanbul-based economist with Global Source Partners. Simsek pitched Erdogan on increases that would reach 25% over 18 months, local press has reported.
That’s inadequate to the problem at hand, Ucer argues. “Too much gradualism, like half-pregnancy, will not work under the current circumstances,” he says.
Investors expect inflation, which peaked at 85% last October, to reaccelerate later this year, as winter fuel costs and the amazing shrinking lira kick in. “We’re probably right around the bottom of the disinflation cycle,” TCW’s Antin says.
All that said, Turkey’s government and bankers have shown great ingenuity in paying their most pressing bills, including state debt. Erdogan has used the country’s geopolitical presence, as a bridge between Europe and Asia and NATO member on speaking terms with Vladimir Putin, to engineer tens of billions in swap agreements from Qatar to China. Russia itself fronted Turkey at least $10 billion last year to complete construction of a nuclear power plant by Moscow-owned Rosatom.
Against that background, default on Ankara’s hard-currency bonds looks remote for the time being, and 9% attractive compensation for the small risk. “Turkey has been living on the financial edge for quite some time,” Al-Hussainy says. “Most worst-case scenarios are already priced into the dollar bonds.”
You might bet on Erdogan that much, but no more.
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