The Turkish lira is facing an inflation spiral and its central bank may need ‘outside help’ to fight the crisis and regain foreign investors’ trust, Commerzbank says

Person counts Turkish lira bills
  • Markets are seeing a repeat of the 2018 crisis, which was also triggered by presidential policy, Commerzbank said.
  • The Turkish lira is facing the risk of a damaging inflation spiral, according to the bank.
  • Turkey’s central bank may need ‘outside help’ to fight the crisis and regain investors’ trust, the bank said.
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The Turkish lira has hit record lows this week, domestic markets are in turmoil after the surprise sacking of the head of the central bank and the currency is facing a crisis and a damaging inflation spiral, according to analysts at Commerzbank.

“The next lira crisis is upon us,” Tatha Ghose, a foreign exchange and emerging markets analyst, at Commerzbank said in a note on Tuesday.

President Recep Tayyip Erdogan installed the third central bank chief in just two years earlier in the week, firing incumbent Naci Agbal, whose approach to monetary policy had won the confidence of domestic and foreign investors alike. Agbal last week raised interest rates to 19% from 17% to head off a pickup in inflation, angering Erdogan, who has made clear he believes higher interest rates boost inflation. This contradicts traditional economic theory, which argues the reverse.

Inflation could now spiral to over 20% by the end of the year as a result, Commerzbank’s Ghose said.

“…He must truly believe that lower interest rates will solve Turkey’s current macroeconomic problems even in the short-term; otherwise it is difficult to believe that the president would risk another lira crisis already, when private sector balance sheets are reeling from a massive FX liability burden,” he said, referring to Erdogan’s macroeconomic beliefs.

“We saw similar presidential involvement in monetary policy right before the last lira crisis in 2018,” Ghose said. “This particular experiment risks ending in an FX-inflation spiral,” he added.

Whilst it is impossible to predict what form the new Turkish monetary policy will take, it is highly likely that interest rates will be cut back to around 13%, which will cause inflation to strongly accelerate in the next nine months, the Commerzbank report said.

The value of the lira against the US dollar is likely to depreciate and risks going exponential, but medium-term policies and developments are impossible to predict, Ghose wrote.

Following the firing of Agbal, investors fled the Turkish market on Monday. The benchmark Borsa Istanbul 100 index had fallen over 5% at close, but turned positive on Tuesday, similarly the lira recovered slightly. It is however still at record lows against the dollar and investors are continuing to pull funds from the Turkish market. The yield on the benchmark 10-year sovereign bond was up by more than 1 whole percentage point on the day at 19.24%, the highest since the last lira crisis in 2018.

By starting yet another cycle of unstable monetary policy, Erdogan “has thrown monetary policy credibility out of the window,” Ghose said. Even policies designed to stabilize the central bank, or rate hikes would not be enough to calm investor worries, as this cycle has repeated itself too often by now, he said.

“For the lira to stabilize, some sort of regime change, or institutional hand-over may be necessary – for example, under IMF supervision – which will restore credibility,” Ghose said.

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Turkish lira crashes as much as 14% after the firing of the head of the central bank sparks market turmoil

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A foreign exchange office in Istanbul, Turkey.

  • Turkish President Recep Tayyip Erdogan fired the head of the central bank after he raised interest rates last week.

  • The lira fell by as much as 14% against the dollar as foreign investors fled Turkish assets
  • The government says it will continue to follow a free-market and liberal foreign exchange regime.
  • Sign up here for our daily newsletter, 10 Things Before the Opening Bell.

The Turkish lira fell as much as 14% on Monday, after President Recep Tayyip Erdogan sacked the head of the central bank, Naci Agbal. Investors fled Turkish assets after Agbal’s departure, whose appointment had increased confidence and trust in the country’s monetary and macroeconomic policies.

Since Agbal’s appointment in November 2020, the lira had regained some strength and stability, as domestic and foreign investors responded well to his more traditional macroeconomic policies. Previously, Turkey’s unconventional approach to monetary policy had made many investors cautious and the lira suffered as a result.

Agbal raised interest rates to 19% from 17% on Thursday. The rate hike boosted the currency, but went against Erdogan’s belief that higher interest rates raise inflation. Agbal’s replacement, Sahap Kavioglu, shares this opinion.

“Mr Agbal’s replacement, Sahap Kavcioglu, is a little-known business school professor who shares President Erdogan’s economics theories and is, unsurprisingly, associated with the ruling party. Turkey will be an interesting example of what EM can expect if inflation fears rise markedly, with markets nervous about inflation in developed countries and punishing asset classes accordingly,” Jeffrey Halley, senior market analyst at OANDA, said on Monday.

Turkish finance minister Lütfi Elvan has however stated the country will continue to follow a policy of free markets and a liberal foreign-exchange regime. A statement by Kavioglu also said the Turkish central bank “will continue to use the monetary policy tools effectively in line with its main objective of achieving a permanent fall in inflation”.

The falling lira dragged on the benchmark Borsa Istanbul 100 index, which tumbled by as much as 9% on Monday, as investors fled the domestic market.

The heightened nervousness of fixed income investors was also reflected in the stark price fall of the benchmark Turkish 10-year bond. Its yield rose by as much as 300 basis points to around 16%, on Monday, its highest since August 2019. Yields move inversely to prices.

Growing concerns over economic and currency instability following Agbal’s dismissal, especially relating to shifts in interest rates and inflation, have raised the risk associated with Turkish assets and led investors to pull out of Turkish markets across the board on Monday.

The long-term strength of the Turkish economy and the lira are now in jeopardy, Rabobank senior emerging-market strategist Piotr Matys said.

“Essentially, the risk that the CBRT could make the same policy mistake as in 2019/2020 is high. To reiterate the point we have made on numerous previous occasions, Turkey cannot afford to have negative real interest rates when inflation is substantially above the official 5% target,” Matys said.

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