Executive summary

• Turkey’s central bank sharply increased its lending rate by 300bps on May 23rd
• This comes on the back of Turkey’s weakening currency and persistent inflation as an economy dependent on foreign capital – worsened by rising oil prices and political interference
• Tracking the development over the coming days will be key in gauging the central bank’s commitment to fighting inflation and the market’s perception
• Our fundamentally-based local currency weighting scheme is underweight Turkey versus the market cap benchmark
• We expect short-term spillover to other emerging markets but see it is as a buying opportunity for EM countries with relatively stronger fundamentals such as India, Russia and China.

Following a month of intense pressure on the Turkish Lira (TRY) and repeated market calls for official intervention, the Central Bank of Turkey (CBRT) took action last night at an emergency meeting by hiking the Late Liquidity Window Lending (LLW) rate by 300bps to 16.5%. All other rates were left unchanged, however, the Turkish central bank reiterated that it ‘will continue to use all available instruments in pursuit of the price stability objective’.

The move comes on the back of heavy depreciation in the TRY, down roughly 23% against the US dollar since the start of this year. Concerns stem from the country’s persistent double-digit inflation and a lack of concerted response from the central bank. The situation is exacerbated by a current account deficit of over 5.5% of GDP, leaving the economy highly dependent on inflows of foreign capital.

Consequently, the economy is subject to a negative feedback loop, where spiraling inflation damages investor confidence, which in turn causes capital outflows, leading to TRY depreciation, which again feeds back into increased inflation. This is without even considering the impact of rising oil prices on Turkey as a net oil importer, which only worsens the economy’s inflationary dynamics.

President Erdogan has consistently expressed his unconventional economic view that high interest rates are the cause of inflation, and that they should be cut to achieve price stability. Despite rhetoric from the CBRT that such a policy is not in their interest, the upcoming elections are set to increase the President’s powers substantially, raising serious questions about the institution’s independence.

The CBRT’S only intervention seen this year was on April 25th, when the LLW rate was hiked by 75bps. However, considering the reactive rather than proactive nature of the move, it was perceived as merely papering over the cracks.

Although this time round the hike was more substantial in magnitude and is certainly a move in the right direction, the near 15% depreciation in the TRY versus USD since the last hike produces questions as to whether this is genuinely an escalation of the Central Bank’s efforts, or simply more of the same. Indeed, these concerns have been somewhat reflected in market sentiment: the 6.5% appreciation in TRY following the announcement has seen a  4% reversal today (as of writing).

Tracking the events over the coming days will be key in gauging the central bank’s commitment to fighting inflation and the market’s perception. We think expected real rates need to move to around 3% to 5% before stronger evidence of future economic stability emerges. In addition, the populist fiscal policy easing, which has been a major driver behind the pressure we are seeing on Turkey, would need to be addressed as well. The good news here is that elections are just around the corner (June 24th), which we believe make the likelihood of policy shifts more likely, as most of the impact on the real economy will fall after the elections. 

Given the current focus on emerging markets (EM), on the fixed income side, our Fundamental Fixed Income (FFI) EM local currency weighting scheme is underweight Turkey versus the market cap benchmark, as we see it as vulnerable on the basis of the fundamental factors we use an inputs to the process. In addition, our rules-based Sustainable Development Goals (SDG) integration has also been creating a penalty for Turkey, given the country's low SDG scoring versus its per capita income level (a proprietary methodology we use).

In terms of broader spillover risks, Turkey is an example of a series of questionable policy choices and external vulnerabilities under an environment of tighter financial conditions, in our view. We expect short-term spillover to other emerging markets but see it is as a buying opportunity for EM countries with relatively stronger fundamentals such as India, Russia and China.

For professional investor use only.
This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393.
Lombard Odier Investment Managers (“LOIM”) is a trade name.
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