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Rate Increase Bets Fade as Lira Gives Room to Cut: Turkey Credit

Governor of the Central Bank of Turkey Erdem Basci
Erdem Basci, governor of Turkey's central bank. Photographer: Goh Seng Chong/Bloomberg

The rebound in the world’s worst-performing currency is diminishing the likelihood that Turkey’s central bank will raise interest rates to stem the highest inflation in 19 major emerging markets, trading in the swaps market shows.

The cost to lock in two-year borrowing costs through interest-rate swaps tumbled to 392 basis points above the benchmark one-week repurchase rate on Feb. 17 from 570 basis points on Jan. 5, data compiled by Bloomberg show. The 5.75 percent benchmark rate sets the floor of a corridor within which Erdem Basci, governor of the Central Bank of the Republic of Turkey, varies lending rates. He’ll probably hold that rate unchanged at a monetary policy meeting tomorrow, according to all nine economists in a Bloomberg survey.

Basci, 45, introduced the dual interest rate policy in October and drove banks’ borrowing costs to close to the 12.5 percent ceiling of that range while selling $18 billion of foreign-currency reserves to support the lira as an exchange rate depreciation of 18 percent last year drove inflation to 10.5 percent, a three-year high. This year, the lira has gained 8.6 percent against the dollar, fueling the biggest decline in bond yields in emerging markets and helping the central bank pare its inflation outlook to 6.5 percent by year-end.

“Turkey’s central bank will wait for further indication that inflation is falling to cut rates -- they won’t do it at this week’s meeting, but as soon as they can,” Agnes Belaisch, who helps manage about $2.5 billion in emerging-market debt at Threadneedle Asset Management in London, said in an e-mail in answer to Bloomberg questions. “The strengthening of the lira is passing through to help achieve the central bank’s objective of reducing inflation.”

Growth Target

Lower rates would support Prime Minister Recep Tayyip Erdogan’s goal of achieving at least 4 percent growth this year for Turkey’s $735 billion economy, after the fastest expansion behind China among major economies last year. Economists expect growth to slow to 2.7 percent in 2012, according to the median of seven estimates compiled by Bloomberg.

Basci has the power to vary overall borrowing costs on a daily basis by adjusting the amount of funding he may provide at three rates: the lowest one-week rate and overnight rates at 12 percent and 12.5 percent. Daily flexibility is essential to manage volatile inflows and outflows caused by the European sovereign debt crisis, he told journalists in Istanbul on Jan. 31.

The monetary policy committee will announce its decision on rates tomorrow at 2:00 p.m. in Ankara. Basci has kept the benchmark one-week rate on hold at 5.75 percent since a 50 basis-point cut to an all-time low on Aug. 4.

Swap Premium Drops

Now interest-rate swaps, which show bets on the average lending rate in liras in two years, are approaching levels just before the August meeting, when the premium over the one-week repo dropped to 333 basis points, or 3.33 percentage points, data compiled by Bloomberg show.

As the lira hit an all-time low of 1.9219 per dollar on Dec. 28, Basci pushed the average of the three rates close to the 12.5 percent ceiling to stabilize the currency. The bank has now eased the aggregate rate to as low as 7.5 percent after it resumed funding at 5.75 percent on Jan. 10, according to economists including Ibrahim Aksoy of Istanbul-based Sekerbank TAS and Emre Tekmen of Turk Ekonomi Bankasi AS.

Currency Swaps

The cost to exchange lira payments for dollar payments in two years dropped to 7.32 percent at 6:01 p.m. in Istanbul from 9.5 percent on Jan. 5, the highest since Dec. 14, 2009, a further sign that investors see lower likelihood of fresh tightening, according to so-called cross-currency swap rates on Bloomberg.

The outlook for Turkish interest rates is shifting after the third-best currency rally in Europe, the Middle East and Africa this year. The lira, trailing only the forint’s 12 percent gain and the zloty’s 9.5 percent appreciation in 2012, gained 0.76 percent today to 1.7411 per dollar.

The advance has helped send yields on benchmark two-year lira bonds to a 2012 low of 9.21 percent on Feb. 17 from 11.48 percent at the end of last year. The yields dropped 7 basis points, or 0.07 percentage point, to 9.14 percent today, according to a Royal Bank of Scotland Group Plc index of the securities.

The extra yield investors demand to hold Turkey’s dollar-denominated bonds rather than U.S. Treasuries declined 43 basis points to 342 since the end of 2011, JPMorgan Chase & Co.’s EMBI Global index shows. Serbia, whose debt carries the same BB rating from Standard & Poor’s as Turkey, has a spread of 568 basis points, 33 basis lower than the end of last year.

Yield Decline

Turkish credit-default swaps fell 5 basis points to 250 today, compared with a spread of 210 for Russia, rated three levels higher by S&P, and 218 for Poland, rated five levels higher, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately-negotiated market.

As of last week, Turkish default swaps cost 29 basis points less than the average for countries in central and eastern Europe, the Middle East and Africa included in the Markit iTraxx SovX CEEMEA Index. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a government or company fail to adhere to its debt agreements.

Slower Inflation

A sustained strengthening in the exchange rate may mean inflation will slow by more than the central bank forecast, Basci said on Jan. 26 in Davos, Switzerland, in an interview with Bloomberg HT television. While inflation was more than double the central bank’s medium-term target of 5 percent in January, Basci said consumer-price increases have peaked and will slow in May before dropping again in the fourth quarter.

The rate will fall to 6.87 percent in 12 months, according to the average estimate of more than 80 economists and executives in a fortnightly published by the central bank on Feb. 8. The prediction fell from an average 7.2 percent forecast two months previously. Inflation was 33 percent when Erdogan’s Justice and Development Party took office in 2002 and slowed to a four-decade low of 4 percent in March last year.

The central bank’s forecast for inflation is based on “the tight monetary policy stance being maintained a while longer” and the lira showing “a moderate appreciating trend,” the bank said in a report on Jan. 31.

Growth ‘Volatility’

While policy makers’ primary goal is price stability, any increase in interest rates to tame inflation would “create volatility” for economic growth, Basci said the same day.

“The central bank thinks that meeting the inflation target in the short-term will be very costly and that it would be wrong to trigger a recession to get to the official goal,” Yarkin Cebeci, an economist for JPMorgan in Istanbul, said in a Feb. 16 telephone interview. “There’s no use in insisting on inflation when the world doesn’t care about it and is focused on stability.”

Growth in Turkey’s economy, the eighth-biggest in Europe and about half the size of Russia’s, has started slowing. Turkish gross domestic product expanded 9.6 percent in the first nine months of last year from the same period of 2010. Even Erdogan’s goal is less than half that pace and below the average annual rate of 5.9 percent since 2002.

‘Current-Account Problem’

Viktor Szabo, who helps manage $7 billion in emerging-market debt at Aberdeen Asset Management in London, said Basci is unlikely to drop his interest-rate corridor any time soon.

“The ultimate target of the central bank is growth” and Basci thinks “low rates are needed” to achieve that goal, Szabo said by telephone Feb. 16. “But now you’re running into a high inflation problem and you’re running into the current-account problem.”

Turkey’s cumulative 12-month current-account deficit ballooned to a record $78.6 billion, or about 10 percent of GDP, in October before falling from November and ending the year at $77.1 billion, according to data from the central bank in Ankara. Economists including Tim Ash at Royal Bank of Scotland Group Plc in London have called on Basci to drop his corridor policy and raise rates to help curb the demand for imports that’s widening the deficit.

The deficit will shrink this year, Basci said in Davos on Jan. 26. Erdogan’s government expects the gap to narrow to 8 percent of GDP at the end of this year and 7.5 percent in 2013, according to medium-term economic plans published on Oct. 14.

Rates Flexibility

The current-account deficit is a “core concern” and will push the central bank to stick by its variable rates policy, William Jackson, an emerging markets economist at Capital Economics in London, said in a telephone interview Feb. 16.

“They’ll be maintaining the corridor policy because this gives them the flexibility to respond quickly to any deterioration to investor risk appetite,” Jackson said. “After all, the current-account deficit is still at 10 percent of GDP and it still looks unsustainable.

The deficit may be 9.5 percent in the second half of this year and 8.5 percent at the year-end, Goldman Sachs Group Inc. economist Ahmet Akarli said in an e-mailed report from London on Feb. 12, adding that a ‘‘lasting improvement looks unlikely.’’ Two days earlier, he increased his forecast for 2012 economic growth to 2.5 percent from a previous 0.5 percent citing a better global outlook.

Foreign investor inflows buoyed by Federal Reserve and European Central Bank policies mean that financing the current-account gap won’t be a problem this year, Basci told executives in Bursa, a city in western Turkey, on Jan. 6.

ECB Pumps Liquidity

The ECB pumped a record 489 billion euros ($643 billion) into the euro region in December to ward off a funding squeeze caused by the sovereign debt crisis. The Fed kept the option open for a third round of bond purchases after its January meeting and pledged to keep its benchmark interest rate at a record low of about zero percent until late 2014.

Investors poured $13.7 billion into Turkish government debt and equities this year compared with a decline of $2.7 billion in the first five weeks of 2011, central bank data show.

‘‘Turkey has become again an attractive country to invest as investors have become more familiar with the central bank’s policy approach,” Threadneedle’s Belaisch said.

Citigroup Inc., Vodafone Plc and General Electric Co. are among foreign companies that invested in Turkish assets over the past decade, seeking a foothold in an economy whose population grew by 1 million last year to 74.7 million.

Foreign direct investment was $3.3 billion in December, up from $1.9 billion a year earlier, the central bank said Feb. 13. The inflows surged 74 percent in 2011 to $15.7 billion, the bank said.

“The central bank no longer sees the need for high funding rates,” said Selim Gulkan, a fixed-income trader at Turk Ekonomi Bankasi in Istanbul, a unit of France’s BNP Paribas SA. “The main reason for this is the foreign interest in Turkish and other emerging markets following the expansive policies of central banks in developed countries.”

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