Beyond July 6: Is this only a governor removal or a shift in macroeconomic policy?
On July 6, 2019 the governor of the Central Bank of Turkey (“CBOT”) was removed by President Recep Tayyip Erdogan (1). The mainstream view, as reinforced by President’s comments, is that of a deeper cut by the CBOT at the July 25 meeting.
Given current weekly policy rate of 24% (compounded to 27% annually), the real interest rate differential ex-post is nearly 12%. Given the fact that Turkish interest rates beyond Venezuela and Argentina is double of South Africa’s and the major central banks moving relatively dovish, there is ample room to cut rates while still providing a globally competitive gross rate. Given a lackluster 2018 GDP growth of 2.6%, IMF expects a 2.5% GDP contraction for 2019 (3). The high real interest rates have been instrumental in keeping Turkish Lira (“TRY”) anchored since hitting 7.23 per USD during August 2018. From that point on, TRY has appreciated to be 5.72 as of July 12, 2019 even with inflation at a declining double digit path (4).
As shown above in Bloomberg HT’s graph, the blue line is the average funding rate (effective funding cost, not the policy rate) is considerably above the orange line which is the CPI rate. In tandem with these developments, market participants upped their rate cut expectations to 200 basis points (6). Similarly the general consensus is of 500 basis points cut until the end of the year.
I have a different opinion and that is of a deeper cut than expected for July 25. Furthermore as indicated by Mert Yilmaz in his YouTube channel, the Ankara political debate and inclination is of a more medium term change than a simple higher rate cut operation (7). It seems there is a growing understanding that lower interest rates would be beneficial for Turkey’s growth. Relative weakening of TRY as a result could be tolerated to a degree and could prove beneficial as a hedge against political risk and to promote export competitiveness. In addition, the CBOT could step in to support some of the new initiatives to ease the bad debt overhang on the banks & the corporates. This would be inflationary in tandem with TRY depreciation, however this inflationary impact can be contained given a tighter budget and slow economic activity. I will share my thought on this after I outline what I expect to happen.
First of all I would be surprised if the July 25 rate cut is lower than 300 basis points. I expect 300 to 500 basis points cut from that meeting. Furthermore I expect a total of 750 basis points cut for the remainder of the year (to 16.5%). This will drive the TRY weaker but given high local savings in FX (USD 185 billions), there will be a wealth effect that will help consumer spending in combination with the lower interest rate effect. I expect public support to companies with FX debt and benefits to those companies with export exposure due to a weaker TRY. Furthermore, I assume no problem in debt rollovers. So if the public sector curbs excessive spending spree of 2018 & 2019, then the resulting inflationary risk (albeit significant) can be compensated by progress on other fronts. This would be especially true if governance standards in general are addressed and public sentiment improves.
In addition, let’s review the political perspective. President Recep Tayyip Erdogan is planning to hold rallies to thank the electorate in August — September period. He would hold these rallies when interest rates are cut and the economy starts to respond. While purely cyclical, inflation is likely to fall below 10% as of September (8). This will be amplified by the President as a testament to his lower interest rates lead to lower inflation theory. Consequently, as the CBOT lowers rates, lower inflation figures up until December will follow on. While a major political risk or a TRY depreciation beyond 7.50 could put upward pressure on inflation beyond 20%, even that would be with a time lag. Furthermore around 6.50 might not change the 12–15% expectation for 1Q20. So the President could ride the wave of higher growth, lower rates and TRY depreciation in to a politically stronger 2020 in which Turkey is likely to see amendments to constitution (via referendum or parliamentary approval) and/or new center right parties spinning out of AKP. A shift in current economic policies might be perceived as helpful in that regard as well.
Please note that this analysis disregards major positive / negative political externalities but beyond that a more competitive TRY which would be supported by fundamental economic adjustments to reduce import dependency in Turkey will be more beneficial than an artificially supported TRY. If the public finances are significantly improved by cutting expenses and bad debt issues are handled, a lower TRY and lower interest rates could help to kick start economic activity. However in order for this effect to be long lasting, there has to be meaningful improvements in the governance quality in the short run and education quality in the medium term. In summary, contrary to the current mainstream expectation, the removal of the CBOT governor might be one of the early signals of a deeper change in macroeconomic policy. If the July 25 rate cut is 300 basis points or more, we would see a confirmation of this shift.
July 14, 2019