Turkey's Interest-Rate Shock Treatment May Not Be Enough

Imagine waking one morning to discover that interest rates had more than doubled overnight. It happened today in Turkey, as the central bank at an emergency meeting late on Tuesday raised key lending rates to as much as 12 percent. The dramatic action was intended to shore up Turkey’s lagging lira currency and stem an alarming flow of capital out of the country. Alas, it may not have worked.

After posting gains early in the day, the lira began sinking again and by day’s end was at 2.24 per dollar, some 4 percent weaker than at the beginning of the year. “Turkey would appear to have received the worst of both worlds,” Michael Shaoul, who heads Marketfield Asset Management in New York, told Bloomberg News today. “Local economic activity can be expected to be constrained by massive monetary tightening, while foreign investors are hardly likely to be enticed.”

The central bank’s move put it at odds with Prime Minister Recep Tayyip Erdogan, who has championed low interest rates as part of his pro-growth policies. But the lira has plunged to record lows in recent weeks as Erdogan’s government became embroiled in a corruption scandal—a situation made worse by a global selloff of emerging-market assets. The bank raised its one-week repo rate, which it said should be treated as a benchmark, from 4.5 percent to 10 percent. Its overnight lending rate rose from 7.75 percent to 12 percent.

The increase could help with “rebalancing” the economy, slowing growth from 3.6 percent in 2013 to an estimated 2.5 percent this year, says Tim Ash, chief emerging-markets economist at Standard Bank in London. It also could narrow Turkey’s worrisome current account deficit, which reached an estimated 7.1 percent of GDP last year.

Still, Turkey remains “one of the most vulnerable emerging markets to any slowdown in capital inflows,” Neil Shearing, chief emerging-markets economist at Capital Economics in London, says in a note to clients today. Turkey’s external-financing requirement is more than twice the amount of its foreign-currency reserves, the highest rate of any major emerging economy, Shearing says.

Continued political turmoil could spook foreign investors and undermine the lira further, says Charles Movit, an economist at IHS Global Insight in Washington. And higher interest rates could aggravate the turmoil, as borrowing costs rise and growth slows. “Let’s not forget that the trigger for the selloff was political,” Abbas Ameli-Renani, a strategist at Royal Bank of Scotland, writes an e-mailed report. “That very much remains in place.”

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