November MPC: Waiting For Further Hikes

The monetary policy committee raised 1-week rate by 50 bps to 8% and the upper band by 25 bps to 8.50% vs a consensus expectations split between a 25 bps hike in the 1-week repo change and no change. As a separate decision, the central bank has decreased FX reserve requirements by 50 bps for all maturity brackets, providing $1.5 billion of liquidity to the financial system.

The move came despite the politicians’ strong remarks against high real interest rates, but after Turkish lira has weakened almost 9% against the US dollar (even underperforming the Mexican Peso). To our thinking, this was a rational move but not enough to reduce near term risks. The rate statement noted that despite the disinflationary slowdown in aggregate demand, recent exchange rate movements ─owing to heightened global uncertainty─ posed upside risks to the inflation outlook while it did not provide much forward guidance.

The average cost of funding rate was standing at 7.9% just before the decision, and according to our estimates the rate hike could add another 35 bps, taking it to 8.25% in days to come. That said, we have already seen it rising to 9.05% in two days following the rate decision. We believe much of the devaluation in the local currency has been driven by global market conditions, and Trumpflation trade is likely to lead further downside. While our 2016E USD/TRY target of 3.2 is overshot by a wide margin, we renew our 12-month horizon target at 3.65 for the currency. We also believe that 25 bps hike in the ceiling of the rate corridor may not provide sufficient incentive for deposit holders to stay in TRY.

turkey-real-interest-rate-and-core-inflationPreviously, we draw a pessimistic future for the inflation outlook in 1H17. Correspondingly, we see further rate hikes by the central bank going forward, and expect the average cost of funding to hit 10% next year, in an effort to provide a compelling real interest rate for TRY holder. In our view, the recovery signals in Q4 ─after a dismal Q3─ on the lending growth front, would provide some comfort for the central bank for tightening. That said, we earlier stated that it was more likely to see fiscal stimulus to support the economic activity in the future (we expect Turkish government to post a budget deficit of 2% as of GDP in 2017).

Turkish Banks: Funding Challenges Ahead

Time and time again, we concerned ourselves with volume growth trends in Turkish banking spectrum. As is the case with any emerging market, credit growth in Turkey has been phenomenal since interest rates cut to near zero in developed economies. That being said, deposit growth has been weak mostly due to the fact that interest rates on savings have remained subdued. Turkish central bank has failed to keep the equilibrium real interest rate at a level that would boost savings and reduce inflation.

At the end of January 2016, L/D ratio for all Turkish banks reached a record level of 115%. Particularly, the spread has been widening since mid-2013, highlighting that local currency depreciation expectations led a shift in sentiment in deposit market. Turkish Banks Loans to Deposits Ratio

Banks have inevitably faced instability on shake-up of funding base, which pushed them to diversify. It was December 2010 when Turkish lenders almost had not debt securities issued on their accounts. Then Turkish corporate bond market started to show first signs of life as the financial institutions pioneered. Now outstanding debt issued roughly amount to 100 billion in Turkish lira terms (of which only 30% were local currency denominated).

Outstanding Debt Securities Issued by Turkish Banks

But we believe the crucial point lies in the relationship with the central bank. For the past twelve months, we have seen CBT funding increasing significantly, helping the banks to meet their short-term obligations and ultimately preventing a lack of liquidity. It is also interesting to see total volume in interbank markets slowly rising.

Turkish Banks Borrowing From Central Bank and Interbank Market

This may be underpinning Turkey’s inexpugnable M2 money stock growth which we somehow call Turkish quantitative easing. Having a great respect for CBT without fail, things are getting heavier for the bank’s hard task ahead.

Finally, remember that average cost for CBT funding has risen above 9% recently which would curb the bank’s earning through higher interest expenses. In interbank market, the rates are standing at 10.75% where the banks are becoming more reliant on. With all that, average of interest expenses incurred by Turkish banks will eventually rise, and, more importantly, bond yields unlikely to fall below 10%, that will continue to put pressure on asset prices.

Turkish Central Bank Lost It?

Since 2006 Turkish central bank has officially been in pursuance of price stability after reforms such as law amendments regarding the formation of the bank differ the way the bank function. Until 2009, the bank irrefutably had been on the path to achieve price stability. However, in the following years, we have seen the bank using non-conservative tools to reach the desired results that have unsurely included the price stability.

Over the past five years, Turkish central bank has failed to lower the inflation rate to 5%, which it set a long-term target for the price stability, while the rest of the world has struggled to slay deflation. According the December 2015 inflation report, consumer price index in Turkey increased by 8.81% y/y. Food prices have been heavily accused for the higher than expected increase which were up 13.7% (nonprocessed foods). This was highly elusive given the country’s food self-sufficiency. But, more importantly, I-index which excludes food, drink, and energy prices (or core inflation as some say) rose by 9.5%, which clearly reveals the central bank’s painful failure.

Tightening was simply what was expected from the central bank in such cases. Turkish central bank referred to the U.S. Federal Reserve’s policy normalization as the trigger to simplify its own monetary policy. However, after the Fed move in December, Turkish central bank kind of postponed its own normalization process, referring this time to high volatility in the financial markets as a prerequisite. As this was one of the worst cases ever happened in the history of communication in central banking, its credibility got shredded again, worsened already dismal expectations. Now, according to the participants of the survey of expectations, a Turkish central bank reaching its inflation target is unlikely to occur in two years.

It is a fact that Turkish central bank has become less and less resistant to political pressures, as concerns about the bank’s independence have remarkably risen. If so, one should argue that the central bank has also lost its influence on the rates in the credit markets. In other words, politicians’ repeated calls for lower rates to boost growth has resulted in or are to result in with a monetary policy that lacks ability to impact interest rates. See the chart below.

At this point the famous issue of output-inflation trade-off springs to mind, and what is so interesting about the Turkish case is that the central bank has presumably managed to fail in both sides. This all has been a central-bank failure of epic proportions.