Risks of the Turkish Lira against hard currencies

Since the start of the week, the value of the Turkish Lira has depreciated amid statements from top political figures in Ankara suggesting that a military operation in Syria’s Afrin region is imminent. On Jan. 16 alone, the USD/TRY rate rose from 3.73 to 3.83.

The U.S. dollar has tumbled around 5 percent against the euro over the past month and the EUR/USD parity reached 1.2250, so the current USD/TRY rate shows a relatively higher lira basket of the U.S. dollar and the euro exchange rate compared to where it was back in December.

There are a number of fundamental risks that could prompt a further depreciation of the lira.

Risk 1 - The Central Bank sacrifices the lira: Dollarization continues.

Around this time last year, annual consumer inflation - excluding food and energy prices (core inflation) - was 7.7 percent. By December 2017 it had hit 12.3 percent. Core inflation was up 4.5 points, nearly 2.5 times higher than the annual inflation target.

But the Central Bank was slow to react - both in terms of timing and in terms of interest rate action. At that point, the Central Bank raised the upper band of the interest rate corridor to 12.75 percent, up from 11 percent: Just a 1.75-point increase. As a result, the average cost of the liquidity that the Central Bank provides to the market has increased by 3.1 percentage points. And core inflation has surged as the Central Bank lags behind, with locals buying foreign currencies and adding an extra $20 billion to FX deposits held in local banks.

Ahead of the December meeting of the Central Bank’s rate-setting commission, messages were sent out that rates “would be raised” and this increase “would be satisfactory.” However, the outcome of the meeting fell short of expectations, with rates rising only a half a percentage point.

After the December meeting, some analysts whispered into the ears of market players that more rate cuts could follow in January, just to keep the mood up. But this also went up in smoke. As a result, the U.S. dollar has weakened 5 percent against other currencies over the past month. The continued fund inflows into emerging markets and the relative depreciation of the dollar cannot possibly end the problems.

As of yesterday, analysts did not expect the Central Bank to raise interest rates at the meeting scheduled for Jan. 18. But if the Central Bank does not raise its rates at all, or lifts the rates just for the sake of it, this will only fuel further depreciation of the lira over the medium term.

If the Central Bank, which is not taking necessary steps against inflation, fails to grasp the importance of external developments then it may find itself in deep trouble. By then it could be too late.

Risk 2 - The impact of a potential U.S. fine

Aside from its size, a possible fine from the U.S. Treasury over Turkish state lender Halkbank’s violation of sanctions on Iran may hamper Turkey’s bid to find external funding. The prospect of such a fine is hanging over Turkey’s financial sector like a Sword of Damocles. A sizeable potential fine and the unpredictable impact of this fine will inevitably put the lira under even more pressure.

Risk 3 - The year ending easy monetary conditions

The U.S. dollar has weakened nearly 5 percent in international markets over the past month because Japan’s Central Bank has reduced bond purchases. It is also widely believed that the European Central Bank, taking inflation and economic growth in Europe into account, may end its bond purchase program in September.

Most people think this is all temporary. It is most likely that, following the footsteps of the U.S. Federal Reserve, the European Central Bank and the Japanese Central Bank may end their expansionary monetary policies and employ tighter policies.

Risk 4 – The U.S.: The return of inflation

The “biggest threat” is the return of inflation to the U.S in the near future. This will force the Federal Reserve to raise rates and hit the breaks even harder.

Fed officials now openly acknowledge such a possibility. In a speech last week, New York Federal Reserve Bank President William Dudley clearly said annual inflation would rise above 2 percent. “The Federal Reserve may therefore have to press harder on the brakes at some point over the next few years. If that happens, the risk of a hard landing will increase,” Dudley said.

Many market players increasingly believe that the Fed, which lifted rates by 0.25 points five times over the past two years, may raise its rates by 0.25 points a total of four times in 2018. I think dollar inflation may come back much stronger than anticipated and this may force the Fed to lift interest rates by 0.5 point each time towards the end of the year.