Wall Street Is Baffled as Turkey’s Reckoning Over Rates Arrives

The two former Wall Street bankers now at the controls of Turkey’s $900 billion economy are confronting a market that’s more divided than ever.

(Bloomberg) — The two former Wall Street bankers now at the controls of Turkey’s $900 billion economy are confronting a market that’s more divided than ever. 

Central bank Governor Hafize Gaye Erkan and Finance Minister Mehmet Simsek, with nearly two decades of experience at US investment banks between them, have been given the reins of policymaking at a time when the biggest global lenders are sharply at odds over Turkey’s path forward from an era of ultra-cheap money. 

The drama will come to a head on Thursday when the central bank reviews interest rates for the first time since President Recep Tayyip Erdogan cruised to reelection in May. Shortly after, he overhauled an economic team that investors hope will fix an inflation crisis he helped create.

Analysts are unanimous that Turkey will raise rates for the first time in more than two years. But they disagree significantly over how big the hike will be, according to a Bloomberg survey.

The spread of forecasts for the one-week repo rate — which now stands at 8.5% — is the widest on record. Goldman Sachs Group Inc. is at the top end, predicting a huge jump of 31.5 percentage points to 40%, while Standard Chartered Plc estimates a more modest increase to 14%.

More than a third of respondents in a poll expect a move to 20%. That would still keep the benchmark nearly 20% below zero when adjusted for inflation of 40%, leaving it as the world’s lowest real rate among more than 50 economies tracked by Bloomberg.

Read more: Turkey’s Simsek Signals Gradual Shift to Conventional Policy

“Probabilities are more skewed toward a gradual adjustment than a speedy one,” said Bank of America Corp. analysts including Zumrut Imamoglu, who predict a move to 25%.

The split reflects the ambiguous guidance from both Erdogan and Simsek since the election — and the stark choice they face in steering an economy thrown off balance by years of extreme monetary easing and constant state interventions meant to prop up the lira.

Turkey has spent close to $200 billion to support the currency in the last 18 months, depleting reserves as it kept interest rates artificially low. It’s still down more than 20% this year, the worst performance among major emerging currencies after Argentina’s peso.

The central bank pulled back from defending the currency earlier this month, in a move largely welcomed by investors. But it proved brief, with state lenders restarting buying the lira after it dropped 7% in one day.

Thursday’s decision may mark the biggest step yet in a return to economic orthodoxy and set the tone for Erdogan’s new administration.

But investors are still skeptical that Erdogan — a self-described “enemy” of high interest rates who’s espoused the benefit of loose monetary policy for years — will give Erkan free rein. 

Simsek, a former Merrill Lynch bond strategist, joined Erdogan’s cabinet as finance chief five years after he resigned from similar roles under the president. Erkan worked for nearly a decade at Goldman and her appointment boosted expectations among traders that Simsek can recalibrate Turkey’s economic model.

What Bloomberg Economics Says…

“Mindful of the macro-financial stability risks that could arise from rapidly hiking, it is our view that the policy flip will materialize as a gradual tightening cycle. New Governor Erkan’s banking background strengthens the likelihood of a slower approach, due to concerns related to regulations that resulted in commercial banks increasing their holdings of long-term government bonds.”

— Selva Bahar Baziki, economist. Click here to read more.

Erkan has said little in public since being appointed less than two weeks ago. Simsek has acknowledged the need to adopt “rational” policies. But he also told the nation’s top business and banking executives on Friday that he wants to tread carefully to avoid unwanted side-effects, suggesting he’s wary of raising the cost of money too sharply.

Erdogan indicated his support for Simsek but also said his economic views haven’t changed. In 2020, the president allowed a brief return to conventional monetary policies, but ended up sacking then-Governor Naci Agbal for increasing rates too aggressively. 

The president, who’s on his fifth central bank governor in four years, has maintained that lowering the cost of money will eventually result in slower and more stable inflation, a belief that goes against the core premise of major central banks around the world.

Another Constraint

As Simsek and Erkan embark on a mission to end Erdogan’s growth-at-all-costs strategy, they’ll have to contend with the legacy of years of tinkering by Turkish regulators. 

The challenge now is how to untangle the patchwork of rules that’s saddled banks with low-yielding lira government bonds while keeping the currency on a leash. Rate hikes — if they are too aggressive or delivered too quickly — might erode lenders’ buffers and put stress on the financial system.

The average yield on lira deposits for up to three months of maturity is nearing 40%, a sign domestic investors want considerably higher rates to maintain savings in the local currency.

A compromise by the central bank would be to settle for a rise in the benchmark to 15% while shifting funding to lenders through costlier channels, according to Bloomberg Economics. Such a move would bring the policy rate in line with the cost of loans to Turkish corporates.

The Monetary Policy Committee is likely to start gradually bringing the benchmark closer to lira deposit rates without causing stress on the financial system, according to Morgan Stanley economists Hande Kucuk and Alina Slyusarchuk, who predict an increase to 20%.

“Enhancing credibility to lower inflation expectations will not be an easy task, in our view, given the strong political preference for low rates in the background,” they said. “Following the initial normalization steps, the MPC will likely adopt a more hawkish tone and signal further rate hikes to lower inflation expectations.”

–With assistance from Joel Rinneby.

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