London, Istanbul, Reuters—The Turkish central bank’s latest tightening may briefly boost the lira, but the currency could need far higher interest rates to protect it from the current emerging markets rout.
The bank’s decision on Tuesday to raise the upper end of its interest rate corridor—the so-called lending rate at which it funds the market—by 50 basis points came with a pledge for more tightening if required.
Chances are it will have to deliver sooner rather than later. Emerging markets are highly vulnerable to investment flight because the US Federal Reserve will soon start to turn off the stimulus that has helped fund them in recent years.
Ibrahim Aksoy, an economist at Seker Securities in Istanbul, said Tuesday’s move—which initially lifted the lira—would probably have only a temporary impact. He reckons the central bank will have to raise the average cost of funding significantly in coming months.
“[Today’s] decision may be perceived as positive for the lira and bond market at first sight. However, we believe that only a [bolder] move on the lending rate may calm the forex and bond market.”
The lira’s resilience to the ongoing emerging market selloff has been remarkable so far.
Markets have zeroed in on the currencies of countries with funding deficits, seeing them as the biggest losers from U.S. plans to pare back money printing. The fear is that a so-called sudden stop in capital flows to emerging markets could result in balance of payments crises across the developing world.
Hence the selloff on the Indian rupee, Indonesian rupiah, South African rand and Brazilian real—with current account gaps ranging from 3 percent of economic output in Brazil to 6.5 percent in South Africa, these countries are seen as most vulnerable to any pullback in global liquidity.
Turkey, with a 5 percent gap, should be among the most vulnerable.
Add to that real interest rates. The differential between interest rates and inflation is just 125 basis points in Turkey, among the lowest of the big emerging markets.
In Brazil for instance, investors can get a real yield of around 600 bps while in Indonesia it is over 300 bps.
“Real interest rates are too low and the current account deficit is too high [in Turkey],” said Claire Dissaux, head of global economics and strategy at Millennium Global Investments.” The real interest rate of round 125 basis points … is not enough to compensate for the risk of holding a currency with such a large current account deficit.”
But the lira is down only 0.8 percent this month against the dollar while the rupee, rupiah and real have lost over 3 percent. This may be down to the resolute policy stance compared with what analysts see as a more piecemeal approach in India and Brazil.
“Turkey’s central bank has a bit more credibility in investors’ minds than the Reserve Bank of India and the Bank of Indonesia,” UBS strategist Manik Narain said, noting past episodes in 2011-2012 when those betting against the lira got burned by the bank’s aggressive policy tightening.
But economists said Tuesday’s rate hike was less hawkish than it first appeared as it would only raise the cost of funding on days when the central bank takes additional tightening steps by not holding its regular repo auctions. On other days, the cost of funding would be little changed.
The Turkish economy would be at risk if foreigners decided to yank out their cash.
Foreign portfolio flows into Turkey amounted to around 5 percent of its gross domestic product in the past year, UBS data shows, among the highest in the world along with Mexico and double the emerging markets average.
“There is a real risk of contagion… I think Turkey will be the next shoe to drop,” Narain said.
Markets, however, are betting the central bank will do what it takes. While analysts had expected no move at this week’s meeting, swaps had priced a small rate rise and predict almost 200 bps of policy tightening in the coming year.
Already it has become costly to short the lira. One-year implied yields, interest rates derived from the gap between spot and forward rates, have doubled since mid-May to 8 percent.
While this may be scant compensation for the risks and is far below than the 10-15 percent implied yields in Indonesia or Brazil, those markets are arguably in a stickier situation.
“They have made it punitive to go against the lira,” said Guillaume Salomon, a strategist at Societe Generale. “I am happy to hold lira because I know that if the currency comes under pressure I will be rewarded with higher short-term rates.”
“A rate hike now is a signal that they are watching the currency and will allow short-term rates to go higher..but the environment is so challenging that we will need to see that lending rate above 10 percent at some point.”