Turkish Lira: Rising Risks of "Blow-up"

File image of Fatih Karahan, Governor, CBRT. Image: CBRT on Flickr.

The chances of another Turkish Lira "blow-up" are rising, warns a new analysis.

"Chances of a blow-up escalating," says Tatha Ghose, FX Analyst at Commerzbank, in a new research note that details the bank's latest downgrades for the currency.

"We revise our USD-TRY and EUR-TRY forecast paths higher again in light of accelerated depreciation despite sharp, surprise rate hikes," he explains.

The Central Bank of the Republic of Turkey (CBRT) raised its policy rate to 46% from 42.5% in April in an attempt to calm markets and arrest capital flight following fresh domestic political unrest over the arrest of a popular opposition politician.

Typically, interest rate rises help stabilise falling currencies, and can even lead to their appreciation as investors look to take advantage of those higher rates.

However, Commerzbank argues Turkish authorities might be causing more problems than they are solving:

"We think that the central bank’s attempt to manage the exchange rate using layered interest rate tools and FX intervention is backfiring by damaging, not bolstering credibility."

In fact, "the interest rate level no longer matters," says Ghose. "The sizeable rate hikes only had a brief supportive effect on the lira. Thereafter, the rally reversed entirely, and depreciation pressure appears to be accelerating."

The Pound to Lira exchange rate rose 4.67% in April and is up a further 0.70% in May. The Euro to Lira rose 6.46% and 0.73% respectively, while the Dollar to Lira is up 1.32% and 0.60%.

So why is the Lira still falling?

Ghose explains that this divergence between the interest rate level and the lira outcome is not really a contradiction — it is instructive.

"It highlights the damage done by inconsistent policy signalling. Having initially cut rates too rapidly earlier this year, CBT is now scrambling to reverse course after an adverse shock has materialised."

Commerzbank's view is that investors sense a politically-driven reluctance to hike rates and instead resort to complex and opaque tools such as its infamous “rate corridor” – "precisely the framework earlier discarded to improve transparency and credibility."

Commerzbank now forecasts EUR/TRY at 49.28 by year-end and USD/TRY at 44.