Turkey central bank halts rate cutting spree, but the damage is done

Turkey’s central bank kept interest rates on hold on Thursday, surprising foreign investors.

But the lira was little moved by the decision, which comes after nine-straight cuts to the benchmark interest rate.

The central bank has slashed the one-week lending rate to 8.25 percent from 24 percent last July, a campaign of monetary easing that was immediately preceded with a decree by President Recep Tayyip Erdoğan that sacked and replaced the bank’s governor.

After pandering to the government’s pro-growth economic policies for many years with unorthodox tweaks to monetary policy, the decision to replace Governor Murat Çetinkaya with Murat Uysal, a former employee of state-run Halkbank, finally convinced foreign investors that the central bank had lost its independence from political authority.

The rate cuts, which mean Turkey now has negative interest rates of about 3.1 percent when subtracting consumer price inflation of 11.4 percent, have helped provoke an exodus of foreign investment from Turkish stocks, bonds and the lira.

The lira now trades at 6.85 per dollar, almost 20 percent weaker than the 5.58 per dollar it changed hands at on July 1, 2019, shortly before Erdoğan sacked Çetinkaya. The currency is just off a record low of 7.26 per dollar reached in early May.

Foreigners holdings of Turkish local bonds have slumped to 5 percent of total debt stock from 25 percent in 2013. The proportion has halved since January, when it stood at about 10 percent of total.

Meanwhile, foreign ownership of stocks traded on the Istanbul Stock Exchange has shrunk to $23 billion, according to central bank data, from about $82 billion in 2013. The most recent exodus has been prompted by a ban on short selling.

Earlier this week, MSCI Inc., the provider of benchmark share indexes across the world, announced that the MSCI Turkey Index may be downgraded to a frontier market from an emerging market, putting it on a level with Vietnam, Bangladesh, Morocco and Serbia. Such a decision could prompt further outflows of around $5 billion, analysts say.

Since last year, the central bank, keen to support the government’s efforts to stimulate economic growth following a currency crisis in 2018, has regularly confounded investor expectations with bigger rate reductions than anticipated. The pattern has continued during the COVID-19 pandemic, effectively making investment in local bonds less and less attractive.

At the same time, the bank has worked with other Turkish authorities to prevent local banks trading with foreign financial institutions in the offshore swaps market in an effort to stop short selling of the lira and to bolster the currency’s value. It has introduced a local swaps market on the Istanbul Stock Exchange as a replacement.

Meanwhile, Uysal has introduced tweaks to banks’ reserve requirements to help encourage a boom in lending to consumers and businesses.

The policy, coupled with a surge in loans approved by the state-run Vakifbank, Halkbank and Ziraat Bank, controlled by Erdoğan via chairmanship of the Turkey Wealth Fund, has meant that consumer and business loans grew by 20 percent over the past year. The borrowing includes 920,000 consumers who have never taken out a loan before.

Non-performing loans stand at 5.4 percent of total and could double over the coming year, according to ratings company Standard & Poor’s.

Economists and analysts had expected the central bank to lower the benchmark interest rate by 25 basis points, or 0.25 percentage points, to 8 percent on Thursday, according to the median estimates in polls of economists and analysts conducted by Bloomberg and Reuters. Some had anticipated a 50-basis point reduction.

The predictions were based more on the bank’s past dovish behaviour than on economic fundamentals. Annual consumer price inflation of 11.4 percent in May was some four percentage points higher than the bank’s year-end goal of 7.4 percent, which was lowered from 8.2 percent in April to give room for more rate cuts. A monthly survey of economists by the central bank in June predicted inflation at 9.5 percent in December.

With a long list of missteps by monetary policymakers and, more widely, Turkey’s economic institutions, it will take more than one prudent move by Governor Uysal and his monetary policymakers to repair the bank’s reputation, which lies virtually in tatters.

In fact, trading in the lira suggests that many investors were optimistic that the rate-cutting spree would end with a final reduction on Thursday but are now pricing in more cuts going forward, hence further delays to Turkey’s return to economic orthodoxy, which still looks some way off.

Many economists query whether the central bank will be allowed to raise interest rates at all should that be necessary, pointing to Erdoğan’s objections to higher borrowing costs. The president claims that higher interest rates are inflationary, confounding conventional economic thinking. Those assertions helped spark the currency crisis in July 2018.

The opinions expressed in this column are those of the author and do not necessarily reflect those of Ahval.