First steps in tightening Federal Reserve policy resonate in emerging markets dependent on the US dollar. One of the most important markets in them is Turkey.
The Turkish lira has been under pressure in recent weeks as investors have tried to assess whether the country’s central bank will listen to the president’s demands and cut interest rates. But a cut in interest rates could bring down the value of the pound while inflation in the country has already hurt the currency’s ability to buy.
Turkey’s economy is one of the most vulnerable to signs that the Fed intends to raise interest rates because a stronger dollar makes it difficult for Turkey to pay its debt in foreign currencies. Federal Reserve officials said Wednesday they expect to raise interest rates by the end of 2023, earlier than expected in March. This puts Turkey’s central bank policy at risk from potential US attempts to manage its inflation terms down the road.
A move toward a more pious U.S. policy “would be a huge negative surprise for markets and a very negative one for emerging market assets,” said Daniel Wood, investment portfolio manager at William Blair Investment Management. International. “
A stronger dollar will also add pressure to the Turkish lira. The Turkish currency reached a record low on June 4, when it fell to 8.7532 pounds to the US dollar, after Turkish President Recep Tayyip Erdogan called for interest rates to be lowered by July or August.
High inflation weighs heavily on Turkey
Erdogan fired three central bank governors in less than two years and he prefers a low interest rate as part of a strategy to encourage growth. Avoiding a higher interest rate may cause returns to investors to erode. Recently, the price of oil has risen to more than $ 70 a barrel, and this too is expected to encourage inflation in Turkey.
Investors expect inflation to rise worldwide this year because of bottlenecks in supply chains and higher demand for goods and services as epidemic-related restrictions are lifted. While an environment of high growth is typically good for emerging market assets, Turkey may struggle to raise interest rates.
“The careers of central bankers do not depend on interest rates in most countries in emerging markets, so it will be difficult for Turkey to remain competitive in terms of capital flows,” said Eric Myerson, senior economist at Swedish bank Handelsbanken. “Now, good news for the global economy in terms of higher interest rates is not good news for Turkey.”
Turkey has been struggling with high inflation for a long time, and it is eroding the purchasing power of the pound for imports. If inflation climbs above the one-week sales and repurchase rate index (repo transaction), which stands at 19%, returns to investors from other countries will decrease. Central Bank Governor Sahap Kabsiuglo told investors that he would keep the interest rate high from inflation, which stood at 16.59% in May, down 17.14% from April – the first drop in inflation since September 2020.
After Erdogan fired former bank governor Nassi Agbal in March, after raising interest rates several times, foreign investors withdrew $ 1.9 billion from Turkish shares and bonds in Turkish currency. In the ten weeks since, Turkey has returned only about $ 30 million, according to Central Bank.
The return of foreign currency to equities and bonds is necessary to finance Turkey’s gap between imports and exports in what is known as the current account deficit. Turkey burned most of its foreign currency reserves last year as it tried to slow the depreciation of the pound by selling foreign currency and buying back Turkish lira.
Turkey has also struggled to get back foreign money that usually comes in from tourism, because travel is still restricted to residents of many countries, already the second summer in a row. “The tourist season in Turkey is still in jeopardy. They are clearly doing what they can to vaccinate the tourism workers and create as welcoming an environment as possible, but it will be difficult,” Myerson said.