With some luck, Turkish lira defies doubters - for now

August 7, 2019

SULAIMANI — Turkey’s lira has risen in recent months despite Ankara abruptly sacking the central bank governor and risking US sanctions over Russian missiles, silencing for now critics who had warned such moves could cause another currency crisis.

The lira has been a fortunate beneficiary of the US Federal Reserve’s shift to a more supportive stance, which has boosted emerging markets, especially relatively cheap Turkish assets, since the currency hit an eight-month low in May, Reuters reported on Tuesday (August 6).

An escalation this week in the US-China trade war and Beijing’s devaluation of the yuan could prompt the Fed to do yet more to weaken the dollar, giving the lira room to run.

Investors and Turkish officials who were preparing for the worst in the spring have also been pleasantly surprised by US President Donald Trump’s reluctance to punish NATO ally Ankara for accepting delivery of Russian S-400 defenses last month.

Those two plot twists have provided unexpected cover as the Middle East’s largest economy claws its way out of recession, and as President Tayyip Erdogan recovers from shock local election losses by his ruling party.

Turkey's lira is by far the strongest emerging market currency so far this quarter, while its bond returns have jumped from among the worst earlier this year to among the best.

Its prospects now depend on whether yield-hungry investors will keep ignoring the global trade war and buying riskier assets, as well as Turkish authorities’ ability to restore trust in the central bank, shore up debt-laden banks and companies and halt a trend of Turks turning to more stable foreign cash.

“People are piling into the lira,” said Cristian Maggio, head of emerging markets strategy at TD Securities.

“The main factor is external and the Fed being on a path of monetary easing ... and Turkey stands out as the main beneficiary of that.”

The lira was worth 5.53 per dollar on Tuesday, about 10% stronger than the 6.19 in early May, when Goldman Sachs, Societe Generale and others predicted it would slide toward 6.60 and even 7.00 by year end.

TWO WEEKS IN JULY

Those predictions — which could still prove correct — would throw the currency back to levels hit in last year’s crisis, prompted by concerns over central bank independence and a diplomatic spat with the United States.

The lira at its nadir last year shed half its value against the dollar, sending inflation soaring above 25% in October.

Another sell-off this spring echoed 2018, as investors again fretted that the central bank would not keep policy tight enough to support the lira.

A fresh diplomatic squabble also brewed, with US officials warning that economic sanctions would be triggered if Ankara did not scrap its S-400 deal with NATO foe Russia.

But after Trump came away from a meeting with Erdogan in June saying Turkey had been treated unfairly, the Turkish president called Washington’s — and the markets’ — bluff, and Turkey began receiving the S-400s within two weeks.

In another defiant move, Erdogan fired central bank governor Murat Cetinkaya for not following instructions to ease policy.

The central bank under its new chief followed through with Turkey’s biggest rate cut since at least 2003, again stoking worries about independence.

But the lira only briefly wobbled and has led a group of 29 emerging market currencies since July 1, with nearly double the gains of the second-placed Israeli shekel.

Since June 23, when Erdogan's AK Party lost a high-stakes re-run of Istanbul's mayoral election, Turkish bonds have returned 4.2%, the second best in JP Morgan's EMBI emerging markets index. Capital flows have also turned around with $3 billion arriving in June, according to the Institute of International Finance.

Cetinkaya’s sacking and the sharp rate cut “signals a decline in the credibility and independence of the central bank, which increases macroeconomic risks going forward,” said former Fed economist Selva Demiralp, now at Istanbul’s Koc University.

“But market players saw an opportunity to take advantage of cheap bond prices in the short run.” She said the lira could weaken if there are more rate cuts and the government fails to agree a bad debt bailout.

Reuters reported last month that plans have stalled to relieve banks of some $20 billion in loans that construction and energy companies can no longer afford.

LIRA ON TRAIN TRACKS

Other risks loom for Turkey’s $766 billion economy, which is expected to contract this year.

A year-long trend of “dollarisation” has not abated, with a near-record 53% of accounts holding foreign currencies in mid-July, suggesting Turks are unconvinced by the lira’s rally.

Ratings agency S&P said that just 11% of government bonds now held by foreigners “the fate of the Turkish lira relies far more on the sentiment of Turkish resident households.”

Foreign investors have been squeezed by state banks that in March withheld lira liquidity from London’s overnight swap market, often used to hedge positions, and again in May when they sold billions of dollars in international markets.

Those and other government moves, which some saw as steps toward capital controls, have raised costs for foreigners betting against Turkish assets and for Turks buying dollars and euros.

Reuters has not reported any state bank interventions since May, though some investors say it remains a possibility especially given recent lira strength.

The threat of sanctions also still looms.

US lawmakers remain unhappy about Ankara’s S-400 purchase and could act when they return to Washington next month. A dispute over drilling in the waters off Cyprus could meanwhile lead to European Union sanctions.

“There are vulnerabilities around every corner,” said a long time foreign investor who requested anonymity. “It’s hard to avoid the sensation that we come into work every morning to pick up lira on the train tracks.”

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