Turkey’s central bank on April 25 exceeded market expectations by raising its highest interest rate by 75 basis points (bp).

With investors having dumped the Turkish lira (TRY) in recent weeks, the monetary policy committee (MPC) moved to raise the late liquidity window rate to 13.50%, but left the benchmark repo rate at 8%, the overnight lending rate at 9.25% and the overnight borrowing rate at 7.25%.

“Current elevated levels of inflation and inflation expectations continue to pose risks on the pricing behaviour. Upside movements in import prices have increased such risks,” the Central Bank of the Republic of Turkey (CBRT) said in a statement. “Accordingly, the committee decided to implement a measured monetary tightening to support price stability.”

Prior to the MPC meeting the market consensus was for a 50bp increase in the top rate, with analysts concluding that a hike would help reduce the chances of the stressed Turkish economy experiencing a hard landing ahead of the June 24 snap presidential and parliamentary elections called by President Recep Tayyip Erdogan last week.

Erdogan regularly makes statements going against conventional monetary wisdom—Turkish markets have been crying out for a substantial interest rate cut for an extended time, but the outspoken president has persisted in calling for cheaper money, even claiming that such a move would send Turkey’s sticky double-digit inflation down given the particulars of the country’s emerging economy—but he will perhaps take the tightening in his stride if it firms the embattled TRY and financial markets ahead of voting.

Assessing the hike introduced by the CBRT, Nicholas Spiro, a partner at Lauressa Advisory in London, was quoted by Reuters as saying: “Today’s rate hike is a step in the right direction and shows Erdogan’s decision to call a snap election has placed a heavy premium on the stabilisation of the wilting lira.”

He added: “Yet the fact remains that it will take a sharper and sustained tightening in monetary policy to rein in inflation and restore confidence in the lira. The central bank’s credibility is still badly damaged.”

Market "was primed for a sell-off"
Timothy Ash, senior emerging markets sovereign strategist at BlueBay Asset Management, remarked in a note: “The CBRT does the right thing, and actually positively surprises the market by hiking the LLW by 75bp. The consensus was 50bp, but the market was primed for a sell-off if the CBRT had failed to hike.”

He added: “I think this rate hike, remember in the heat of an election campaign, is a reflection of the difficult challenges now being faced on the economy front with concerns of overheating—a widening current account deficit and double digit and sticky inflation.”

Nevertheless, Ash noted that if anything the rate increase was more about anchoring the exchange rate this side of the elections “rather than showing steel in the fight against inflation. At present, Turkish consumer confidence and likely partially electoral preferences will be driven by the stability of the lira from very depreciated levels”.

While ranking as landmark elections in that they will trigger potentially epoch-making constitutional changes—creating an all-powerful executive president, scrapping the position of prime minister and greatly weakening the role of parliament—voting will still be significantly driven by the state of the economy. Analysts see the economic gains and jobs delivered by the ruling Islamic-rooted AKP in the past 15 years as the party’s key point of appeal to the electorate. “And,” added Ash, “in this rate hike, the CBRT and I think the AKP just affirmed that when push comes to shove, they get it—there are limits to their more unorthodox behaviour.”

Lira started year at 3.79
One of the worst performing emerging market currencies in the world this year, the TRY started 2018 at around 3.79 to the dollar and plummeted to an all-time low of 4.1944 on April 11. The devaluation turned into a dizzying descent as worries mounted about growing imbalances in Turkey’s surging credit-fuelled economy—which posted ‘warp-speed’ growth of 7.4% in 2018, outdoing China—and fears persisted over the possible undermining of central bank independence. By around 1830 Istanbul time, the rate hike seemed to have made little impact on the value of the TRY. It was trading at 4.0991, very little changed day on day.

Turkey’s annual inflation rate hit a 14-year high of 12.98% last November but has since eased back to March’s 10.23%. However, the central bank's latest survey of economists' inflation expectations for the year-end, released on April 19, produced a forecast of 10.07%, from 9.49%. Analysts said that fact alone increased the odds of monetary tightening.

Turkey’s Deputy Prime Minister Mehmet Simsek, who leads the government’s economic team, said last week that bringing inflation down to single-digit levels remained a government priority. New limits on borrowing in foreign currency should help reduce the lira’s volatility, thus curbing inflation, he added.

Given the uncertain outlook, options traders have remained more bearish on the lira than any other emerging-market currency except Russia’s ruble. Traders have been looking to guard against more weakness. Risk reversals showed the premium on contracts to sell the ruble and Turkey’s lira versus the dollar in a month’s time over those to buy were about 3pp and 1.9pp, respectively, the highest across developing nations, according to Bloomberg data.