Last-Resort Tightening Looms as Lira Turns Tables on Turkey

Turkey’s Central Bank Governor Erdem Basci was so confident he had tamed inflation and bolstered the lira that in January he dangled before investors the possibility of emergency rate cuts to strengthen an easing cycle.

Three months later, after Basci lowered the bank’s main rate by 75 basis points to 7.5 percent, the currency and government bonds have slumped to become the year’s worst-performing securities among emerging market peers.

Speculation has now switched from how fast borrowing costs would fall to when they may go up, raising the prospect of another bruising confrontation with a government determined to prevent a rate rise two months before a general election. The most likely outcome is a period of muddling through, says Ibrahim Aksoy, a strategist at HSBC Asset Management in Istanbul.

“Prospects for cutting or raising the interest rates are both poor at the moment, yet it would be wiser to increase should the lira’s depreciation continue,” he said. “The central bank will probably only consider a rate hike in the case of a sharp lira decline like the one in January last year.”

President Recep Tayyip Erdogan has led the attacks on Basci for hindering economic growth ever since the governor delivered a midnight rate increase in January 2014 to stem a run on the lira. Although the two reached a truce last month following a slide in the currency, analysts question whether Basci would dare to increase interest rates without getting Erdogan’s approval first.

Election Goal

With the economy slowing ahead of June’s election, Basci will exhaust all tools at his disposal to defend a currency that hit new lows on Wednesday before he considers changing rates, said Philippe Dauba-Pantanacce, a senior economist at Standard Chartered Plc in London.

“The central bank will mostly continue to do what it has done for a while: use every possible tool but the policy rate to tighten liquidity, resulting in higher market rates,” Dauba-Pantanacce said by e-mail Wednesday.

Erdogan hails from Turkey’s main Islamist-rooted political movement that sees interest payments as a violation of religious principles. He also wants the ruling AK Party to win the two-thirds majority in parliament that would allow him to change the country’s constitution in favor of a presidential system.

Liquidity Measure

Basci is no stranger to Turkish politicians’ calls for lower borrowing costs and has learned how to manage them since being appointed to the post in 2011. An unorthodox three-tier interest rate corridor allows Basci to alter the lira’s liquidity on a daily basis while keeping the official rates unchanged.

Basci kept overnight interbank repo rates, a key barometer that shows how tight liquidity policy is, at 10.74 percent for 14 days in a row through Wednesday. That is more than three percentage points above his benchmark rate and is only one basis point shy of the highest value interbank rates can reach without Basci having to announce an official tightening.

In an apparent attempt to defend the currency, the central bank on Tuesday gave advance notice of measures it may take at its April 22 meeting. Policy makers will discuss lowering the rate charged for foreign-currency loans to banks, according to the statement. That’s an instrument hardly used by commercial banks that last benefited from it in December 2012, Aksoy said.

Record Lows

An increase in payments to banks for their required lira reserves, another measure announced by policy makers, may be beneficial to the banking industry but its impact on the lira will be limited, according to Pinar Uslu, a strategist at ING Bank AS in Istanbul.

The lira fell as much as 1.6 percent to a record 2.7310 to a dollar on Wednesday, extending this year’s depreciation to 14 percent, the worst-performing currency among 24 emerging markets tracked by Bloomberg. It later trimmed some of its losses and was trading at 2.7032 per dollar at 5:15 p.m. on Thursday in Istanbul.

Continued lira weakness beyond 3 per dollar could force another rate increase, said Piotr Matys, an emerging-market strategist at Rabobank in London. Such a run on the currency may not materialize if new economic data supports the view that the U.S. Federal Reserve will not raise interest rates before the last quarter, he said.

“It’s really incredible how quickly everything has changed” in Turkey, Matys said. “Only few months ago we were discussing how far the central bank could cut rates. Before we know it, the market will start discussing at what lira level the bank may have to raise rates.”

(An earlier version of this story incorrectly stated the day of the central bank’s statement.)

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