Last November we witnessed an unprecedented turnaround. As part of the struggle to stabilize the exchange rate of the Turkish lira and foreign exchange reserves, a man was appointed to the post of governor of the Turkish central bank, who succeeded in regaining the confidence of foreign investors. But it was last year, this year the situation is different. No one but Turkish President Erdogan took care of the change.
The Turkish lira was one of the most weakening currencies for most of last year. A key factor in the trend was the combination of the effects of the coronavirus pandemic, which Turkey was addressing through massive fiscal expansion. The result was a widening current account deficit acting as a major factor in the weakening exchange rate. In November, however, a change came. Naci Agbal, who proved to be an advocate of orthodox monetary policy, was appointed governor of the Turkish central bank. For some time, he also had the support of Erdogan himself, who then announced that Turkey was ready to make bitter decisions if they were needed to improve the economic situation (we wrote here).
And that improvement eventually came. The Turkish lira suddenly became the most intensively strengthening currency, which was the result of several rounds of rising Turkish interest rates. The last one happened last week. As part of the fight against inflation and the inflation outlook, still on double-digit numbers, Agbal announced a one-off increase in interest rates by 200 basis points to 19%. Given Turkey’s inflation situation and efforts to restore weakened foreign exchange reserves, this was an adequate step. But not from President Erdogan’s point of view.
The weekend saw the news of the removal of Nacigo Agbal from the post of governor of the Turkish central bank. He was replaced by Sahapa Kavcioglu, a notorious banking professor at Marmara University with a political history within the Justice and Development Party. Kavcioglu has previously spoken out against the policy of raising interest rates. In his newspaper column, Yeni Safak lamented that it was sad to see other columnists, bankers and business organizations seeking economic stability through higher interest rates. According to him, the central bank should not insist on high interest rates. At a time when interest rates are at zero in the rest of the world, this is exacerbating Turkey’s economic problems. Moreover, in line with President Erdogan’s vision, he said that rising rates would open the door not to lower inflation but to higher inflation.
So there are indications that interest rates in Turkey will fall again. The reaction of the markets speaks for itself, which at the beginning of Asian trading showed a sharp weakening of the lira against the dollar by 17%, which was the second largest shift after 2018 in the last 20 years. Weekly implied volatility against the dollar then rose above 50%. At the same time, we observed an increase in five-year credit default swaps of more than 100 points above the 400-point threshold last achieved in November. This morning, we see a decline in Turkish stocks, which on the Istanbul Stock Exchange even led to the activation of trading “brakes” suspending trading.
The situation in the case of the Turkish lira is even worse, as interbank liquidity has deteriorated significantly over the last year. According to Citi data, from January 2020 to January 2021, we observed a roughly 40% decrease in daily interbank volumes and more than a 300% increase in spreads. This basically means that less market depth exacerbates price fluctuations, even though volumes are lower than before.
Looking ahead, we can prepare for another outflow of capital from the Turkish economy. According to Bloomberg, gross reserves, including gold and the bank reserves of commercial banks at the central bank, fell by 20% to $ 85.2 billion between last year, from the beginning of the year until the inauguration of former governor Agbal. Of this, net foreign exchange reserves fell by more than half to $ 19.6 billion. Goldman Sachs estimates that the Turkish central bank intervened last year against the weakening of the lira worth more than $ 100 billion.
According to data from the Trading Economics server, the volume of foreign exchange reserves rose to almost $ 54.5 billion with the advent of Agbal’s Orthodox monetary policy. The slight decline in recent weeks has been linked to the overall outflow of capital from emerging markets, driven by rising longer US market rates. This, combined with the new one with the Turkish governor, who is estimated to cut interest rates by at least the last increase of 200 basis points, poses a clear risk of weakening for the lira. The risk is all the stronger due to low levels of foreign exchange reserves. If we witnessed a significant flight of foreign money from Turkey, measures such as capital controls could come into play, which is by no means positive for market sentiment.
Apparently, we are getting into a situation similar to August 2018, when capital flows to Turkey stopped due to sanctions, which led to a sharp weakening of the lira. The freezing of foreign capital then caused a tightening of financing conditions and a recession, which in turn caused the current account to turn from deficit to negative. In addition, the fact that today’s situation is linked to ongoing anti-pandemic measures around the world also does not affect Turkey, especially on the part of exports.
The key issue will be a possible spillover to other markets, as this is exactly what we observed in 2018. This will mainly concern the currencies of emerging markets. Examples of the more “sensitive” ones are, for example, the South African Rand or the Mexican Peso, which are already depreciating more than half a percent today. The currencies that interest us the most, ie the region of Central and Eastern Europe, weaken only very slightly. We do not speculate that Turkish events should have a significant and long-term impact on the currency segment of emerging markets. For them, the further development of US rates in connection with the shift of the longer end of the yield curve will have a much greater impact. If we see further growth in real US rates, emerging market assets could come under pressure again. We currently see this as one of the biggest risks in the rest of the first half of the year. In the latter, the situation could be facilitated by the gradual opening of economies and the assumption of economic recovery. At the same time, we are betting, for example, on the koruna, which, in addition to stronger values, should also be supported by the prospect of an increase in CNB rates.
Disclaimer: This article is for information purposes only and does not serve as an investment recommendation under Act No. 256/2004 Coll. on doing business on the capital market. In preparing this article, the author relied on publicly available sources. Roklen Holding as and Roklen360 as are not responsible for any errors in the text or data.
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