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In a surprise move that might help the Turkish Lira to stabilize, Central Bank of the Republic of Turkey (CBRT) raised its benchmark interest rate by 2 percentage points on Thursday, its first hike in two years to fight inflation and support its falling currency. The Monetary Policy Committee headed by the central bank’s governor Murat Uysal said that it had decided to increase the policy rate from 8.25% to 10.25% “to restore the disinflation process and support price stability.”

Turkey’s economy is suffering from one of the deepest downturns in its history. According to the Financial Times, the gross domestic product (GDP) shrank 11 percent in the period from April to June this year compared with the first quarter of the year.

The Central Bank had long resisted pressure to raise the key interest rate due to pressure from Turkish President Recep Tayyip Erdogan to keep rates low. Lower interest rates tend to weaken a currency but boost economic growth and inflation. The Turkish President Erdogan hates hiking interest rates and has even linked interest rates with evil. He has been heard saying that, “interest rates are the mother and father of all evil.” In his unorthodox view of economics often known as “Erdoganomics”, higher rates will only fuel inflation. This shows that he fundamentally misunderstands the role of central banks.

The Turkish President also believes that the subsequent increase in the cost of credit would lower economic growth, and, most importantly, job creation. Due to this very reason, the CBRT had gradually reduced the benchmark rate to 8.25% from as high 24% in order to accelerate efforts to keep credit flowing through the economy however since then it kept the rates unchanged. This attempt to fuel the economic activity, however, ended up in creating a credit binge that saw loan growth rise 40% in the past three months, peaking in May at 50%, which is being said to be the fastest rate growth since 2008. The explosion of credit, has been fuelling domestic inflation that was already standing at 11.77% in August year over year(YoY). At the same time, the need for foreign currencies rose in line with rising imports, weakening the Turkish currency even further. This increase in the demand for foreign currencies comes at a time when the Turkish economy is already facing a drought when it comes to dollar inflows due to a massive drop in tourism and dwindling exports as a result of the Coronavirus pandemic.

The Turkish Lira has been plummeting to record lows, dipping to 7.7 against the dollar this week, as the coronavirus pandemic continues to thump the economy. The lira has lost some 20% of its value this year. In order to fight the free fall of the Turkish Lira, CBRT has spent billions of dollars. However after the announcement, the Lira strengthened to 7.62 against the dollar, compared with an all-time low of 7.7 before.

Source : Business Insider - USD to TRY chart
Source : Business Insider - USD to TRY chart

According to an estimate by US investment bank Goldman Sachs, the country has spent nearly $80 billion this year on managing its currency. As a result, its gross currency buffers have dropped by more than a third this year to approximately $43 billion. Including gold, they stand at $86. 3 billion. Despite such massive and unprecedented intervention by the central bank, the Turkish Lira failed to stabilize and continued to plummet to record lows.

What's making matters even worse is the central bank wasn't using only its own reserves, but dollars borrowed from domestic banks, to buy the lira. As a result, it now owes more foreign currency to the banks than it currently has in its coffers.

According to experts, although the decision from CBRT to increase the interest rates was surprising but a hike in interest rates was the only option left for Turkey after it failed to stabilize the Lira by the massive foreign exchange intervention. Experts also say that the CBRT’s action is a step in the right direction and is the first of many actions required to stabilize the Turkish economy.

While speaking to Business Recorder Ugras Ulku who is the Head of EM Europe Research at The Institute of International Finance(IIF) and the former Senior Research Associate in the Macroeconomic Modeling Division at the Turkish Treasury said, "Today's rate hike was more forceful than the market expectation, which should help improve market sentiment and risk-appetite for Lira-denominated assets. With credit growth slowing and the Lira having weakened markedly since mid-July, import growth should moderate during the remainder of the year, which will likely reverse the widening in the current account deficit during the remainder of the year. Higher interest rates could not only trigger net inflows of non-resident portfolio capital but also contain residents’ FX purchases, hopefully helping the Lira to recover some of its recent losses. Curbing residents' strong FX demand might require shifting ex-ante real interest rates meaningfully positive and maintaining positive real interest rates in the period ahead."

It can be said that CBRT’s action of hiking the interest rates the 200bps is a baby step and is the beginning of a very difficult challenge of restoring confidence in the Lira and the Turkish economy. If Turkey wants long lasting stability in the Lira, higher interest rates cannot do the job alone. The Erdogan administration must complement CBRT’s action by coming out of the “Erdoganomics” mode and accelerate the pace of structural reforms.