Commentary: Turkey Must be Steadfast in its Fight Against Inflation.

The Central Bank of the Repulic of Turkey (CBRT) hiked several of key policy rates by unprecedented amounts this afternoon.  The central bank will now charge 12 percent for money overnight, up from 7.75 percent.  By the same token, the bank will now pay member banks with excess reserves eight percent, as opposed to 3.5 percent it had been paying until today. The one week repo rate was raised from 4.5 percent to 10 percent.  Repos, or repurchase transactions are short term funding arrangements where lenders buy highly liquid and safe financial assets from borrowers who agree to repurchase them at a slightly higher price at a specified date. 

 The so-called "late liquidity window" which banks can turn to if they must borrow in the final hour that markets are open, was also raised.  Banks will still earn zero percent on reserves deposited with the central bank after 4 PM, however, they will now pay a hefty 15 percent for the privilege of borrowing late in the trading day, up from 10.25 percent before today's announcement.  

Finally, if Turkey's implementation of monetary policy looks convoluted, that's because it is.  
 Rather than targeting the overnight interest rate between banks, the CBRT offers a variety of funding options to banks and which it can set by fiat rather than through open market operations. A plunging lira and chaotic markets have inspired the bank to simply its operations so as to give it a better handle on guiding markets through the turbulence.   The bank stated that going forward, "central bank liquidity will be provided primarily through the one-week repo rate rather than the marginal funding rate."  

Inflation has remained consistently above the CBRT's five percent target, and the central bank is making its latest move as much a fight against inflation as an attempt to stabilize the FX market.  The bank affirmed that the "tight monetary stance will be maintained until there is a significant improvement in the inflation outlook." 

While Turkey's economy grew 4.4 percent year on year in 2013, a dangerously high current account deficit and political turmoil connected to a corruption probe into the current government has slammed the Lira.  Turkey also has one of the highest current account deficits in the world, coming in at 7.5 percent of GDP.  Normally, currency depreciation would aid  rebalancing of external accounts as exports were made more competitive and imports became more expensive.  Unfortunately, Turkey is a special case since most of its current account deficit is fueled by its heavy dependence on foreign oil and gas.  Since demand its relatively inelastic for these commodities, a fall in the lira might actually exacerbate current account imbalances as local consumers will simply be forced to cope with higher energy prices. 

Markets largely cheered today's actions, sending USD/TRY down to 2.18-19 ranges after hitting an all time high of 2.39 yesterday.  However, some commentators have already said the Central Bank went too far and risks appearing desperate.  In general, I believe that the Bank's credibility will rest on its willingness to take further action should the markets attempt to test its nerve. The Volcker Fed need to hike rates aggressively on several occasions to tame the inflation of the late seventies and early eighties.  It would therefore not be surprising if the CBRT finds itself in a similar position. The Bank also faces political pressures to keep rates low with elections coming in March.  Calls to hike rates from foreign commentators have been called an "interest rate lobby" by PM Erdogan. In sum, today could even be the first step in a principled fight against inflation, or a desperate wild stab aimed at calming markets in the near term but lacking the persistence and resoluteness to fix Turkey's longterm stability issues.    

Other Central Banks from Asia to Latin America have taken action since the brutal EM sell off began last week.  India hiked rates 25 bps to 8.00 percent, while Peru's central bank intervene directly in the currency markets by purchasing dollars to shore up a sliding Nuevo Sol.  However, it is worth noting that unlike earlier EM sell offs stoked by tapering fears, this last week's dip was probably more related to general risk aversion.  The EUR rose against the dollar somewhat, but the big winners were  JPY, CHF, and other safe haven assets.  USD/JPY fell as low as 101.72 from recent highs in the 105.20-30 range.  Treasuries yields also dipped slightly, hardly a indication that investor's fear a sudden increase in interest rates.  

In general, last week's sell off made certain currencies like MXN and KRW very attractive.  Although the ZAR and few other weaker EMs rallied today, that seems to be largely due to market group think.  Going forward, I expect investors to become more selective and reward stronger EMs, while pushing weaker EMs like Indonesia, India, and especially South Africa down even further.