Turkish stocks managed to rise in a shortened session ahead of the holiday, but the lira fell as markets continue to ponder the outlook for a currency that’s beset by an exceptionally unfavorable fundamental backdrop and concerns about central bank independence.
Back in May, in an effort to regain control of the currency after President Recep Tayyip Erdogan’s deadpan Bloomberg TV interview during which he explicitly stated that he would take a more active role in monetary policy following the election, Erdogan let the central bank try an emergency hike to the late liquidity window.
Five days later, CBT simplified the monetary policy framework and on June 7, hiked the one-week repo rate. That hike was met with cheers from the market and a veritable chorus of commentary about the extent to which the central bank had successfully proven its independence on the way to regaining control of the lira.
To say those cheers were premature would qualify as the market understatement of the year.
The simplification of policy entailed going back to the 1-week repo rate, which the central bank effectively ditched more than a year previous. Turkey’s multi-tiered rate regime was (and still is) a source of continual uncertainty for markets. The move to make things more straightforward in May involved setting the one-week repo rate at 16.50% and pegging the overnight borrowing and lending rates at 150 basis points above and below that rate. At the same time, Turkey set the LLW rate (what they were using previously) at 19.5% starting on June 1, which amounted to another 300bps hike on top of the May 23 emergency hike. The June 7 hike noted above took the one-week repo rate to 17.75%, which, according to the new framework, meant the overnight rate moved to 19.25%.
Ok, so last week, the central bank ceased offering one–week repo funding, which effectively forced everyone to use the overnight market. Well, again, the overnight rate is 19.25%, so that’s a stealth rate hike and it’s part of what’s helped the lira regain some of its footing.
(Bloomberg)
Conceivably, they could effectively shutter the overnight market too and force everyone into the late liquidity window, which, if they go that route, would mean rates going to 20.75%, a full 300bps higher than the policy rate.
Do note what this entails. We’ve documented the evolution of this extensively (some of the posts are linked above), and what you should come away with here is that Turkey seems like they’re about to completely negate the changes made on May 28. They’re on the verge of going right back to the late liquidity window in an effort to obscure the fact that they’re hiking rates.
“The CBRT has not offered any funding to banks via the one-week benchmark repo rate since 13 August so nearly all of the banks’ funding requirements during the week of 13 August have gone through the overnight lending rate, whose usage effectively means implementing a rate hike of 150bp”, SocGen’s Phoenix Kalen writes, in a new note out Monday. “If necessary, the CBRT could channel funding requirements to the late liquidity window, whose sole reliance would effectively bring average funding costs to 20.75%, 300bp above the benchmark one- week repo rate”, she adds, reiterating everything said above.
Erdogan undoubtedly understands this, but this allows him to claim he hasn’t succumb to the tyranny of interest rates which, you’re reminded, he calls “the mother and father of all evil.”
This “stealth” hike is in addition to the limits placed on swap transactions last week. As a reminder, that effort was implemented in two parts, one crackdown last Monday and a further curtailment 48 hours later. The mechanics there are pretty simple. “In effect, this measure restricts access to TRY liquidity in the offshore swap market, pushing up short-term borrowing costs, thereby increasing costs for market participants to borrow TRY from local lenders to short the currency”, the above-mentioned Kalen writes, in the same note.
Of course that’s a problem, because what it does is curtail the ability of anyone silly enough to still be holding Turkish assets to hedge. We talked a bit about this last week when the Borsa Istanbul fell some 7% in the third-worst week since the coup attempt.
“Foreign investors exchange their dollars and euros with Turkish liras held by local banks through forward agreements to take directional bets on the currency, as well as to hedge their exposure to the country, so when the BDDK capped local lenders’ swap and swap-like transactions to just 25 percent of shareholder equity on Wednesday, liquidity began to dry up, rates surged and many investors had little option but to offload their holdings”, Bloomberg notes.
Oops. Or not really “oops”. Turkish policymakers surely knew that would happen, but faced with the prospect of an outright currency collapse last week and unable to deliver a shock hike to the policy rate thanks to Erdogan who made things worse by ruling out an IMF program, what else could they do?
(Bloomberg)
Is the respite the lira got from the swaps crackdown and the stealth hike sustainable? Probably not. Here’s SocGen’s Kalen:
Although TRY appreciated significantly during 14-16 August, we do not view that development as a reflection of improved market sentiment toward Turkey. Rather, the TRY rebound reflected the higher funding rates facing lenders, and the substantially higher costs of holding short-TRY positions. Importantly, with the one-shot nature of some of policy instruments employed, it may be difficult for the CBRT to re-deploy the same measures with similar effectiveness in the future.
Again, Turkey could take one more step up with the “stealth” hikes by cutting off the overnight market and forcing everyone to the late liquidity window, but then what? The way the rates regime is set up following the “simplification” effort outlined above, they would need to hike the policy rate (the one-week repo rate) in order to push the other rates higher. But Erdogan isn’t going to like that.
Capital controls would be a disaster considering the country relies on external funding and if Erdogan seized FX deposits and converted them to lira at a rate of his choosing, the lira would obviously plunge anew. But don’t rule it out.
“If a sovereign country decides to freeze, convert, or alter residents’ FX deposits in local banks, it has the recourse to do it”, SocGen warns, adding that “FX deposits constitute a part of the liability side of banks’ balance sheets, and fall under the jurisdiction of the country.”
At the end of the day, barring Erdogan acquiescing to blunt force policy rate hikes and/or instituting credible fiscal reforms, the only “good” option here seems to be to try and capitalize on the Trump administration’s fraught relationship with Europe, Russia and China.
“[Turkey has] engaged in a flurry of diplomatic activity, including meetings with the Chinese president, Russia’s foreign minister, the Iraqi premier, and Qatar’s emir, as well as conversations with the German chancellor and the French president”, SocGen goes on to recount, before noting that Erdogan appears to be “rallying for European nations to band together with Turkey in criticizing the Trump administration’s aggressive trade policies.”
That might well work, but for Angela Merkel and other European leaders, this is a bit of a Sophie’s choice. Do you side with Erdogan who has repeatedly clashed with Brussels over the course of the three-year-old migrant crisis and is a notoriously belligerent autocrat at the risk of infuriating an administration in the U.S. that already wants to slap tariffs on European autos?
Or do you side with Trump and let Turkey descend into chaos at the possible expense of a handful of heavily exposed European banks and at the risk of making the migrant crisis worse at a time when Italy’s Matteo Salvini is digging in his heels on the refugee issue and seems determined to pick a fight about it?
Pick your poison.
