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Eviction of central bank boss shakes investor confidence in Turkey

Recep Tayyip Erdogan’s shock dismissal of Turkey’s central bank chief has eroded investor confidence in the country’s economic leadership that had just begun to rebound after successive waves of financial market tumult.

The decision by President Erdogan at the weekend to dismiss Naci Agbal after just four months in the job during which he engineered a strong rebound in the lira is the latest in a long series of decisions that have worried investors in one of the world’s biggest emerging markets.

Agbal was fired after delivering a bigger than expected raise in interest rates last Thursday — going against Erdogan’s longstanding and contested view that high interest rates cause inflation rather than curing it. He was replaced with Sahap Kavcioglu, a little-known professor and a former lawmaker from the ruling Justice and Development party.

The decision triggered an intense sell-off on Monday in Turkey’s asset markets, with the lira diving as much as 14 per cent and the country’s stocks and bonds sustaining deep losses.

The rout was the latest episode of severe tumult investors in Turkish assets have endured in recent years, in part because of Erdogan’s demand that credit remain cheap to support economic growth, analysts say.

Charles Robertson, chief economist at emerging markets investment bank Renaissance Capital, estimates that less than half of global emerging market investors were willing to own Turkish assets even before the news.

“They missed the rally of recent months and they were OK with missing it because they see Erdogan as too unpredictable and they don’t trust him,” he said. “The number who would be prepared to take a punt now is close to zero.”

Per Hammarlund, chief EM strategist at Nordic bank SEB, said that while short-term financial investment in Turkey would “pretty much freeze up for now”, the danger for long-term investors including foreign businesses with operations in Turkey was that Ankara would double down on its policy errors and prevent them from remitting profits in a bid to protect the currency.

“Erdogan can’t afford politically to have turmoil in the currency markets,” Hammarlund said. With the central bank lacking enough foreign currency reserves to prop up the lira for more than the short term, “either the central bank commits to using interest rates as the main policy tool to bring down inflation — which it is very hard to see working now — or they will have to introduce capital controls.”

Line chart of Lira per US dollar showing Turkish lira sinks after Erdogan replaces central bank chief

Robertson at RenCap said with inflation running at elevated levels — above 15 per cent — and the currency tumbling, the temptation would be to outlaw businesses from raising prices. “Bad policy begets bad policy,” he said.

Turkish officials on Monday underscored the government’s commitment to free-market principles, with the finance minister, Lutfi Elvan vowing “no compromises” would be made in the country’s exchange regime, and Nurettin Canikli, a senior ruling party official, saying the free movement of capital would “continue to be the red line”.

Kavcioglu has in the past echoed Erdogan’s view that high interest rates cause high inflation, which has left investors uneasy about the policies he might pursue after Agbal raised interest rates 8.75 percentage points during his tenure. Still, on Sunday, Kavcioglu said the central bank would “continue to use the monetary policy tools effectively in line with its main objective of achieving a permanent fall in inflation.”

While some analysts said Turkey’s problems would be contained because they were caused by policy decisions unlikely to be copied elsewhere, others said the volatile atmosphere on global markets caused by recent rises in US bond yields left several other emerging economies exposed to rising aversion to risk among investors.

Line chart of Year-on-year change in CPI (%) showing Turkish inflation remains elevated

“The Turkey surprise risks catching emerging markets technically vulnerable, increasing the risk of contagion for [countries] such as Brazil and South Africa,” said Mohamed El-Erian, president of Queen’s College Cambridge and an adviser to Allianz and Gramercy Fund Management.

Robin Brooks, chief economist at the Institute of International Finance, also identified Brazil and South Africa as particularly vulnerable, saying the risk of contagion was “elevated”.

Developments in Turkey, he said, should be seen in the context of depressed economic activity because of the Covid-19 pandemic, a problem shared by other countries along with the pressure from rising US yields.

“The severity of the US bond market sell-off is a major challenge to EM broadly, because higher US interest rates undercut capital flows to EM,” he added.

Last week, along with Turkey, the central banks of Brazil and Russia also raised interest rates by more than investors had expected.

Robertson said they were forced to act aggressively because of the 0.75 percentage point rise in the yields of US 10-year bonds since early January. By raising its policy rate from 2 per cent to 2.75 per cent last Wednesday, he said, Brazil was doing little more than standing still, as any failure to keep pace with the yields on competing assets would deaden the appeal for investors of holding Brazilian government debt.

“Why would you not hold US bonds yielding nearly 2 per cent, when Brazilian short-term debt is paying only slightly more and you can lose 2 per cent in a single day on the exchange rate?” he said.

For that reason, he said, South Africa, too, would be forced to raise interest rates sooner than investors expect.

Analysts say the difficulty for the likes of Brazil and South Africa is that they have very large public debts, which become costlier to service as interest rates rise.

Both countries have suffered especially badly in the pandemic, restricting their ability to recover, although both are commodity exporters and stand to benefit from the recovery in the US expected on the back of the Biden administration’s giant stimulus package. However, any aversion to risk provoked by developments in Turkey would dent their appeal further.


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