Turkey’s economy has taken a drenching over the past week. For at least a couple of months, economic forecasters had seen dark clouds gathering over the economy's unexpectedly fast expansion, swollen with lending from the government’s TRY250bn ($63bn now but $70bn at the start of October) credit guarantee fund (CGF), and highly dependent on hot money inflows from abroad. By early November, inflation, at 11.9%, was at a 9-year high—more than twice the central bank’s 5% target.

With the evidence of the economic overheating becoming irresistible, attention turned to the monetary policy committee (MPC), and after it failed to raise rates, disconcerted markets sent the Turkish lira (TRY) down to an all-time low, perilously close to the psychologically important threshold of 4-to-the-dollar. Turkey's 10-year government bond benchmark yield, meanwhile, was pushed as high as 13.20%.

Of course, President Recep Tayyip Erdogan, has continued to assert his own impenetrable unorthodox economic theory, which says that what Turkey needs right now is not a rate hike at all—but a rate cut, because high interest rates apparently cause inflation.

By now, with the lira down towards 15% against the dollar since September, analysts have no choice but to tackle head-on the question of whether the central bank has lost its independence. Who is calling the shots, the all-powerful Erdogan or the MPC?

No wonder

Germany’s Commerzbank—which has already incurred Ankara’s displeasure this year by arguing that Turkey’s official growth figures are “more than questionable"—didn’t dither, immediately arguing that political pressure to lower rates is “the main reason why the Central Bank of Turkey lacks credibility when the inflation outlook demands higher interest rates”. It was “no wonder” the lira had weakened, it added.

Cemil Ertem, one of Erdogan’s chief advisers, in a November 21 column in Milliyet newspaper, attempted to argue the president's case for loosening, contending that with economies like Turkey’s, where he argues the biggest contributor to cost inflation are charges paid in interest, trying to curb price pressures with higher interest rates is “like throwing gasoline on the fire”.

But the markets aren’t buying it. “Nobody genuinely believes that high interest rates cause inflation, this is populist rhetoric from Erdogan. I’d be very surprised if he himself believes that,” Paul McNamara, a London-based fund manager at GAM, which sold all of its Turkish holdings months ago, told Bloomberg. “The lira is going to keep falling until we see tighter money.”

By the end of the week the lira had clawed back a little territory, hovering around 3.95 to the dollar, benefiting to a degree from a concerted effort from the government's economy team to talk it up as well as silence from Erdogan (but don't expect that to last too long). Ministers and advisers, including Ertem, tried to send the message that the central bank has not lost the right to independently up interest rates should the regulator see the need for it, but at the same time attempted to communciate that there is no actual urgent need for it to make such a move as it had already tightened.

That cases rests on two adjustments made last week by the central bank. First, the regulator tried to reduce some of the impact of forex swings and assauge enterprises in Turkey by selling forward foreign exchange contracts to help them hedge against further currency moves. The contracts amounted to $3bn worth of auctions but they did little to put a brake on the descent of the lira so the central bank then made a second move by from November 22 cutting local lenders’ access to the overnight repo window at 9.25% to zero. That pushed up the weighted cost of lenders’ funds by 25bps with banks' access to all funds now at the central bank’s late-liquidity window at 12.25%.

Incredulous analysts

The second move was seen to make a small impact on the lira market but its main impact was on analysts who were incredulous that this “veiled tightening” could be viewed as sufficient given the steep fall of the currency and surging treasury bond yields. Timothy Ash at BlueBay Asset Management was scathing in a note to investors, responding: “A complete joke—like 25 basis points will make any difference. They are now limping to the next monetary policy committee meeting, which is weeks away and likely will have to have another late night, emergency MPC meeting before then to get the green light from Erdogan for a more substantive rate hike.”

Noting the “general poor geopolitics still around the Turkey story” with investors nervous about Erdogan's falling out with Germany and the EU and his strained relationship with the US, Ash in a November 24 note added: “On the [geopolitics] I still don’t really understand how Erdogan and his advisers continue to kick the interest rate lobby without thinking that Turkey’s external financing position is only currently underpinned by Western portfolio investments (70% of the current account deficit, year-to-date). Have they not thought who actually are the underlying investors in those inflows? It is German, Dutch, Danish and European pensioners, from the very same countries that Turkey's leaders seem to be demonising—true there is fault on both sides with much in terms of the current geopolitical spat, but it would be helpful if the rhetoric at least could be toned down.”

The accumulation of nervousness that Turkey's economy is becoming an accident waiting to happen can be seen across the board. The central bank is hoarding gold, with official data showing it has added almost $5bn to reserves in the year-to-date (though the figure does not separate out metal deposited by commercial banks), while Turks are stocking up on foreign exchange—Nomura International reported resident investors purchased more than $250mn worth of forex in the week ended November 10, bringing a seven-week run of hard-currency sales to an end. That amounts to more bad news for the lira and for Turkish companies that have a combined foreign-currency short position of more than $200bn. Any upsurge in demand for hard currency to meet obligations could drive more depreciation in the lira.

The market seems to think that rate increases amounting to 300-500bps are needed, said Ash, but with the central bank's credibility “shot to pieces... selling a message of the need to hike rates to the Boss is still going to be difficult given that he has spent quite a lot of political capital banging the invisible interest rate lobby [and] it is a bit hard when you have accused the imaginary interest rate lobby of more or less being in cahoots with the organisers of the July 2016 [attempted] coup then to easily do a policy U-turn and hike policy rates”.

Even in Putin's Russia

Warming to his theme, Ash also observed that “I cannot quite think of a G20 economy where their central bank is so lacking in independence as is now the case in Turkey. Even in Putin’s Russia, I think that [central bank head Elvira] Nabuillina has built up enough economic policy credibility with President Putin that she could raise rates without facing a total grilling from the boss”.

Given the central bank's track record of dithering and falling behind the interest rate curve—with notable failures to tighten in time in 2006 and 2013/14—the market, wrote Ash, “has (rightly in my view) concluded that the central bank will only do the right thing, and tighten, when pushed, and this requires extreme market movements which have to come to the point of risking macro-financial stability. We seem to be approaching that point, but I don’t sense we are there yet”.

Looking ahead, analysts are sensing that the date of December 4 could prove to be important where Turkey's economic turbulence is concerned. On that day Iranian-Turkish gold trader Reza Zarrab—who is said by some observers to have been close to the family of Erdogan— is due to go on trial in New York accused of evading American sanctions against Iran by laundering hundreds of millions of dollars, partly with the help of some bankers at Turkish state-run Halkbank. There is speculation, however, that Zarrab has been flipped and will give evidence for the prosecution. US prosecutors have alleged that Zarrab sought support from, and invoked the name of, Erdogan to advance his business interests. Erdogan, who has not been accused of any wrongdoing, claims the case is being driven by figures in the Gulenist movement that he insists was behind the foiled putsch. There are fears that Turkish banks could be exposed to big fines if guilty verdicts are passed.

If the Zarrab case ends up rocking the Turkish markets, the central bank will be under renewed pressure to hike. But should that not occur, it may try and make it to its scheduled December 14 MPC meeting before confronting the demands for tightening again. “It will be totally incomprehensible if the MPC does nothing on December 14, which I think would signal they are throwing in the towel on the lira and indeed in terms of monetary policy in general,” concluded Ash. “It would signal to me that the central bank has no monetary policy stance, but that it is now entirely set in the presidential palace. But can the central bank get to December 14? That seems a very long way off at this stage.”