Is end-game approaching for Turkey’s policy experiment?

October 24, 2011

In less than two months, Turkey will mark the first anniversary of the start of an unusual monetary policy experiment, and it may well do so by calling it off.  The experiment hinged on cutting interest rates while raising banks’ reserve ratio requirements, and as recently as August, the central bank was hoping  it would be able to slow a local credit boom a bit but still protect exports by keeping the currency cheap.  Instead, an investor exodus from emerging markets has put the lira to the sword, fuelling at one point a 20 percent collapse in its value against the dollar.  That has forced the central bank to roll back some of the reserve ratio hikes and last week it jacked up overnight lending rates in an attempt to boost the currency. It has also sold vast quantities of dollars and is promising  to unveil more  measures on Wednesday.

But what the market really wants to see is an increase in Turkey’s main interest rate.  ”Not sure that ‘measures’ short of rate hikes will help,” RBS analyst Tim Ash writes.

Given Turkey’s massive current account deficit of almost 10 percent of GDP, an interest rate of 5.75 percent will provide little protection to the lira if emerging markets come under serious pressure again. Even if the lira stabilises at current levels, an inflation spike to double-digits looks inevitable.  Meanwhile the central bank’s hard currency reserves are vanishing at an alarming rate — just last week it spent $2.7 billion. That’s a lot given Turkish reserves are just $86 billion, or  four months of imports.  Current central bank policy is  ”an open door to reserve depletion,” Societe Generale strategist Guillaume Salomon says,  noting that despite the massive dollar sales,  the lira is not far off record lows hit earlier this month.

Undoubtedly, the central bank’s misfortunes have a lot to do with global sentiment. But the overall verdict on its policies is negative – analysts point out that annual credit growth still close to 40 percent, the current account gap is narrowing far too slowly and inflation is spiralling. Some even predict a recession next year. Ash of RBS argues that a modest half point rate increase now is the way to go and could save Turkey from much bigger rate rises  in coming months.

Many saw last week’s increase to overnight lending rates as a step back towards policymaking orthodoxy.  “The end-game could be higher policy rates going forward,” SocGen’s Salomon says, though he expects the central bank to try a while longer before it throws in the towel on its experiment.

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