What happens to interest rates if dollar/lira rate exceeds the 4-lira mark?

At a time when ministers and advisors are still talking about lowering interest rates, the U.S. dollar/Turkish Lira rate hit 3.92 last week. One wonders how interest rates could be lowered if the local currency keeps depreciating. 

Do you recall that those who said a couple of months ago that the U.S. dollar/lira rate would increase above 4 liras were labelled as over-pessimistic or “apprehensive people.” But nowadays everybody suggests that the exchange rate may hit 4 liras or exceed this level. Almost all bankers argue that the trend for the exchange rate is upward and said that “the rate would have already passed the 4-lira mark, if it had not been [Donald] Trump’s political nonsense.” 

One banker noted the negative decoupling of the lira from its peers which stemmed from widely debated local and international risks, saying that: “The U.S. economic data is strong. The dollar index would increase and the dollar/lira rate would have exceeded 4 liras if Trump had not made those decisions. This, however, can happen in the coming days and the rate can rise well above 4 liras.

The banker added that locals recently sold dollars when the U.S. dollar/lira rate was 3.80, but now some people buy dollars as the rate hovers around 3.89 and this signals that people expect the exchange rate to increase further.

The same banker underlined the importance of the U.S. Federal Reserve’s meeting scheduled for March 20 and March 21 and said that for the time being three rate hikes in 2018 are priced in. If the FED opts to raise rates in March, the lira will sharply depreciate, according to the banker. 

Bankers say all emerging markets will be affected by a possible rate hike in the U.S. But, according to bankers, the lira will suffer the most because investors will first sell off the lira because of higher risks associated with the Turkish currency. 

One such risk is the current account deficit and inflation is not under control, one banker said, adding that roughly $150 million should be generated each day to finance the current account shortfall alone. However, as financing becomes scarce it is difficult to raise this amount of money, thus the exchange rate is naturally rising, the banker noted.

Asked about speculations that the U.S. may impose large fines, the banker said that if this really materializes, the exchange rates will inevitably shoot up sharply.

Will interest rates increase or fall?

According to bankers, the only instrument the Central Bank has in its possession that may help curb the depreciation of the lira is the interest rates. They said that when the lira sharply depreciated in January 2014, the one-week repo rate soared to 10 percent from 4.5 percent and when the U.S. dollar rate hit 3.95 per lira in January last year the upper band of the repo rate was increased by one point. They expect a similar move from the Central Bank if the U.S. dollar/lira rate exceeds the 4-lira mark. 

To summarize, if the depreciation of the lira continues, this will definitely boost expectations in the markets starting next week that interest rates will increase. Those expectations will become more evident if the US dollar/lira rate exceeds the 4 lira-mark. In this case, we may even see calls for the Central Bank to hold an emergency meeting to hike interest rates. 

However, the government appears to be stubborn about lowering the interest rates. Last week, Prime Minister Binali Yıldırım said the government would not compromise on economic growth and they were working to lower the interest rates and they would inform the public soon regarding those work.

To summarize, debates on interest rates are taking an interesting turn. If the local currency keeps depreciating, the markets will expect higher interest rates but the government at the same time will try to lower the interest rates.

We know that the Central Bank management is aware that its options are limited. We also know that it experienced in the past that the pressure for lower interest rates in fact resulted in much higher interest rates. Let’s see what happens.