Originally Posted by
Dudu
In the first Monetary Policy Committee (MPC) meeting of the new political era, the policy rate was kept unchanged in contrast to market expectations. In our opinion, this essentially confirms the markets’ worst fears about the TCMBs independence and the future course of economic policies in Turkey. Based on our observations, unless this policy error is addressed by an emergency rate hike very soon, the markets’ fears could translate into further substantial TRY weakness again. This would put immense pressure on corporate and bank balance sheets, and foreign creditors’ concerns about the balance sheet health of Turkey’s private sector is likely to lead to a contraction in capital flows, which would put further pressure on the currency. Consequently, Turkey would be locked in a vicious circle. Moreover, it is not as if Turkey’s economy would face only an exchange rate shock as a result of the central bank’s inaction. At the time of this writing the 10yr government bond yield is up by 175bp on the day. Thus we think Turkey’s economy is now negatively affected by both exchange rate and interest rate shocks. Unless corrective action is taken very soon, we think this combination could pave the way for a hard landing.
TCMB remains on hold in a disappointing decision
In contrast to our call and market expectations for a 100-125bp hike, the MPC today chose to keep the policy rate unchanged at 17.75%. This was the first MPC meeting after the transition to executive presidency and the appointment of the new cabinet. It also came on the heels of a substantial deterioration in inflation, which jumped to 15.4% in June – up by more than 3ppt over the previous month and more than three times the inflation target at 5%.
Ironically, the rate statement actually acknowledges the deterioration in inflation outlook and notes the generalised price increases across subsectors and highlights the risks posed on pricing behaviour by the elevated levels of inflation and inflation expectations. However, the MPC also notes a more significant rebalancing trend in economic activity, and finds it sufficient to keep the “tight†monetary stance for an extended period.
In another addition to the statement, the MPC says lagged impact of recent monetary policy decisions and contribution of fiscal policy to rebalancing process will be monitored and further tightening will be delivered if needed. It appears that the MPC thinks it has already delivered enough and will now wait to see the impact of past monetary policy moves and future fiscal policy moves.
In our opinion, the problem with this line of thinking is that the TCMB is suffering from a significant credibility gap with inflation widely expected to be about twice the target even in two years’ time, according to the Bank’s expectations survey. Hence, the TCMB does not have the luxury to sit back and wait for inflation to fall. In our view, the TCMB needs to get ahead of market expectations and overtighten if necessary to break the backward-looking price setting behaviour.
Based on our observations, the TCMB’s credibility issue is amplified by investors’ concerns regarding the central bank’s independence under the executive presidency system. These concerns emerged during President Erdogan’s visit to London in May when he promised to assume closer control of economic policy-making after the elections. Hiking rates today would have shown the markets that the TCMB’s ability to tighten is not hindered by Mr Erdogan’s transition to executive presidency.
However, the opportunity to send such a message to the markets was missed. Unfortunately, we think today’s decision essentially confirms the markets’ worst fears about the TCMB’s independence and the future course of economic policies in Turkey. Based on our observations, unless this policy error is addressed by an emergency rate hike very soon, the markets’ fears are likely to translate into further substantial TRY weakness, which would put immense pressure on corporate and bank balance sheets.
Here, we believe, it is imperative for investors to keep in mind that the corporate sector is running short FX positions to the tune of USD220bn (c. 25% of GDP) as of April, and these positions have already led to some large corporates to seek debt restructuring. Against this backdrop it is quite likely that Turkey’s foreign creditors could become concerned about the balance sheet health of Turkey’s private sector. These concerns, which would stem from TRY weakness in the first place, are likely to lead to a contraction in capital flows, which would put further pressure on the currency. Hence we believe Turkey would be locked in a vicious circle. If this negative feedback loop is not broken, we believe Turkey would be pushed dangerously close to a full blown balance of payments crisis, and an emergency rate hike seems to be the only way out of this loop.
There is one more point to note as we conclude: Market participants have often argued that hiking rates to protect the currency would shield the corporate balance sheets from exchange rate effects, but those balance sheets would be hurt by the high interest rates, in our view. Consequently, the authorities may find themselves facing a difficult choice between inflicting exchange rate damage vs interest rate damage.
Based on our observations, today’s price action demonstrates that there is no such trade-off. At the time of this writing, the 10yr government bond yield is up by more than 175bp on the day in response to the central bank’s inaction. Thus we think Turkey’s economy is now likely to be negatively affected by both exchange rate and interest rate shocks. Unless corrective action is taken very soon, we believe this combination will pave the way for a hard landing.
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