Erdogan calls on Turks to support lira, investors fear monetary crisis

Inflation, falling currencies and rapid depletion of foreign exchange reserves: these are some of the risks that emerging market economists and economists are warning of the resignation of Turkish President Recep Tayyip Erdogan from his former central bank chief over the weekend.

The change, which represented the third such withdrawal in two years, caused the value of the Turkish lira to plummet. – but Erdogan says the economy is doing well, telling his AK Party members in government in a speech on Wednesday that this week’s market volatility does not reflect Turkey’s economic reality, according to a Reuters translation.

In the same speech, however, he asked the Turks to sell their assets in foreign currency and gold and buy lira-based financial instruments in an effort to stabilize the besieged currency that has lost 10% of its value since Friday.

“The return of volatility,” read a headline in a Barclays analyst note on Monday. “The risk of a currency crisis increases,” wrote London-based Capital Economics. The report described how former central bank president Naci Agbal, who set out to tackle Turkey’s double-digit inflation by raising its base interest rate by 875 basis points since taking office in November, inspired confidence in investors.

But Erdogan has long had an unorthodox view that higher interest rates cause inflation and are “perverse”. Analysts say it was only a matter of time before Agbal was replaced by someone more pliant to Erdogan’s views, fueling investors’ fears about the central bank’s lack of autonomy and an approaching inflation and currency crisis.

Agbal’s replacement, Sahap Kavcioglu, say many Turkish experts, has no experience in the field and has a history of criticizing interest rate hikes, raising fears of uncontrolled inflation.

“It appears that the central bank’s efforts to tackle the country’s inflation problem may come to an end and a balance of payments crisis has (once again) become a real possibility,” wrote Capital Economics senior emerging market economist, Jason Tuvey. Inflation in Turkey is at 15%, youth unemployment is at 25% and the dollar has risen more than 10% in the lira since the resignation.

“Agbal’s brief dismissal is among the most counterproductive government actions in Turkey’s recent history,” Erik Meyersson, senior economist at Handelsbanken Macro Research in Stockholm, told CNBC. “This will instantly erode any credibility built up during Agbal, increase the risk premium on Turkish financial assets and force the remaining lawmakers to walk an even harder tightrope in the future.”

The Turkish Presidency Office did not respond to a request for comment from CNBC.

When the lira fell dramatically due to similar fears about Turkey’s monetary policy in May 2018, the impact shook many Spanish and French banks, which had significant exposure to Turkish assets. Now, this is less of a problem, says Can Selcuki, managing director of Istanbul Economics Research.

“I doubt that this will lead to defaulted loans that could pose a risk to foreign banks,” he told CNBC. “The level of the lira is not unprecedented, so the business is used to it,” and those who became insolvent did so during the previous fall in the currency, he added.

The Spanish banking sector leads in terms of exposure to the Turkish public sector with $ 14.7 billion in Turkish assets, including government bonds, from $ 20.82 billion in spring 2018, followed by France with $ 6.4 billion, compared to $ 7.1 billion in 2018, according to S&P Global.

And for emerging markets, analysts also see a limited risk of overflowing.

“You can see a limited amount of risk reduction, but I don’t think it will be contagious,” Standard Chartered’s Divya Devesh said on Monday, adding that there may be a reduction in risk for retailers holding Turkish lira, particularly in Japan.

“I don’t think this has the potential to lead to wider market contagion – in the past two years, I think markets have come to see Turkey as a very idiosyncratic EM (emerging market) risk,” he said.

Therefore, the rest of the world may be safer than before, but Turkey seems prepared for a rocky road ahead, especially if the new head of the central bank maintains its dovish outlook.

“The pressure on TRY is likely to increase,” Goldman Sachs analysts wrote in a note on Monday. The previous strategy of the Turkish central bank to sustain the lira was to buy more currency with dollars, thereby burning its foreign exchange reserves.

“A resumption of FX interventions similar to 2020 may be the initial response, but the buffers are comparatively low,” warned Goldman. He estimates Turkey’s gross foreign exchange reserves at $ 35.7 billion – “not big enough to sustain continued interventions, in our opinion”.

The move to Erdogan’s central bank could be the last straw for many, says Tim Ash, senior emerging markets strategist at Bluebay Asset Management.

“It is difficult to see these people coming back – greatly damaging Turkey’s reputation among investors,” he wrote in an e-mailed note on Tuesday. “Those who really trusted Agbal and the history of Turkey are being penalized.”