A Turkish national flag flies outside the University of Istanbul in Istanbul, Turkey. (Photographer: Kostas Tsironis/Bloomberg)

Turkey Unexpectedly Refrains From Rate Increase; Markets Tumble

(Bloomberg) -- Turkey’s central bank stunned investors by keeping interest rates unchanged, defying market expectations and heeding President Recep Tayyip Erdogan’s demands to refrain from raising borrowing costs. Stocks, bonds and the lira plunged.

In its first policy decision since Erdogan won re-election with sweeping new powers, the bank held its one-week repo rate at 17.75 percent, a full percentage point less than the median estimate of analysts in a Bloomberg survey.

“This decision essentially confirms the markets’ worst fears about the central bank’s independence and the future course of economic policies in Turkey,” said Inan Demir, an economist at Nomura International in London.

Even before Tuesday’s decision, investors had become increasingly concerned over the bank’s ability to act independently to contain accelerating inflation. Erdogan pledged during the campaign to exercise greater control over monetary policy, sending the lira to fresh lows. Since being sworn in this month, he’s pushed established figures out of his cabinet and named his son-in-law, Berat Albayrak, economy czar.

The former energy minister has written extensively in support of Erdogan’s unorthodox economic views, most notably that cheaper credit leads to slower inflation. Without directly disputing that stance, Albayrak used his first interview in his more prominent role to voice generally mainstream policies, including that the central bank’s policies should be in line with economic realities and market requirements.

Erdogan’s Clashes

Erdogan, in power since 2003, started a fresh five-year term after winning election under an amended constitution that makes him the country’s most powerful ruler since Mustafa Kemal Ataturk, the father of modern Turkey. The 64-year-old leader had repeatedly clashed with the central bank over borrowing costs that he’s determined to keep as low as possible, though his rhetoric has backfired by triggering policy makers’ to raise rates to support the lira.

Jason Tuvey, senior emerging markets economist at Capital Economics in London, said the decision to leave rates on hold provides the first evidence that Erdogan is intent on holding “increasing sway” over the central bank, which is a negative for investors.

“Pursuing looser economic policy will simply exacerbate the vulnerabilities in Turkey’s economy and, ironically, increase the market pressure on the Turkish central bank to take emergency action,” Tuvey said.

What Our Economists Say...

“The CBRT is banking on a recent run of rate hikes and tighter fiscal policy to keep inflation in check. But this could backfire. Inaction may trigger another vicious circle of capital flight, currency depreciation and runaway inflation.”

--Ziad Daoud, chief Middle East economist, Bloomberg Economics

Read our Turkey React for more

The lira fell as much as 4.2 percent to 4.9384 to the dollar. The Borsa Istanbul 100 Index of Turkish stocks extended declines after the central bank announcement, sliding 3.3 percent. The yield on 10-year lira bonds rose to 18.67 percent, set for the highest close since Turkey began issuing them less than a decade ago.

Read more: The battle over central bank independence explained

Fundamental Fallacy

The lira’s decline against the dollar this year, which at 22 percent is second only to Argentina’s peso among emerging-market peers, has stoked an inflation rate that breached 15 percent last month, more than triple the official target.

In today’s statement, rate setters led by Governor Murat Cetinkaya indicated lira weakness is a contributing factor to inflation, but they also said previous rate increases will eventually lead to slower gains in consumer prices. Monetary policy is tight and will likely remain so for an “extended” period, until the outlook for inflation improves considerably, the bank said.

There is a fundamental fallacy with that kind of thinking, according to QNB Finansbank chief economist Gokce Celik.

“Today’s inaction will necessitate a more sizable action eventually,” Celik said in an emailed note. “We see the currency remaining exposed to further sell-off pressure going forward,” which will exacerbate inflation and raise the risk of a “sharper slowdown in economic activity,” she said.

Foreign lenders, which are vital to Turkey’s import-driven economy, are growing increasingly concerned about the $337 billion of non-lira debt that domestic companies hold. A weaker lira makes it harder for those companies to meet their obligations and discourages banks from lending, creating a “vicious cycle,” according to Nomura’s Demir.

“An emergency hike seems to be the only way out of this loop,” Demir said.

Erdogan and his allies champion a growth-at-all-costs approach to the economy, which expanded 7.4 percent in the first quarter, the most among Group of 20 nations after India’s 7.7 percent. That’s a pace economists say can’t last, so the debate now is whether there’ll be a controlled slowdown or a disorderly crash.

Considering the president’s long-standing views on the economy, Tuesday’s decision shouldn’t have come as a surprise, according to Nora Neuteboom of ABN Amro, who was among the minority of economists in the survey who accurately predicted the decision.

Erdogan has chosen an economic policy of engineered expansion, reckoning that faster growth is the best way to keep money flowing into Turkey, and raising rates would have endangered this strategy, he said.

“The downside of the strategy is that it cannot go on forever,” Neuteboom said.

©2018 Bloomberg L.P.