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Wednesday, June 28, 2006

Turkey economy


The Turkish monetary authorities have resorted to a second sharp hike in interest rates in an effort to arrest the slide of the local currency. These desperate measures are by no means guaranteed success, given the jittery state of financial markets in Turkey and elsewhere, and risk having a damaging impact on the country's economic prospects.

On Sunday June 25th following an emergency meeting of the Monetary Policy Committee the central bank of Turkey decided to raise its overnight borrowing rate by 225 basis points (bps) to 17.25% in a fresh attempt to sustain the Turkish lira, which has been in almost continuous decline since early May. The rate hike came less than a week after the MPC decided to keep rates on hold at its regular monthly meeting on June 20th and less than three weeks since the 175-bp hike on June 7th. In addition, having already intervened directly in the foreign exchange markets on June 13th and June 23rd, the central bank also announced on Sunday that it would hold auctions to provide foreign exchange liquidity (and prop up the lira).

In early trading on June 26th the lira stabilised at about YTL1.69:US$1, 23% down against the US dollar since May 8th when the current bout of financial market volatility began. The initial fall was triggered by the unwinding of carry trades (short dollar positions that have been used to fund investments in high yield countries) as investor sentiment turned negative towards Turkey (and other highly indebted emerging markets). However, domestic political and economic factors sharpened the adjustment, including Turkey 's current-account deficit, rising inflation, its large government debt, substantial external debt-servicing costs, heavy reliance on volatile short-term capital inflows, periodic domestic political tensions and uncertainties about Turkey's EU membership bid.

More pain?

Despite raising interest rates by 400 bps in less than three weeks, the authorities may have to take further action in the weeks or months ahead. If the lira keeps falling, interest rates may need to rise to a level that could do serious, lasting, damage to the economy. At best, a sharp economic slowdown is in prospect. Stronger exports as a result of the depreciation of the lira will only partially offset the negative impact that higher interest rates will have on domestic demand, although weaker domestic demand would have the positive impact of slowing imports and helping to reduce Turkey's burgeoning current-account deficit, which has been one of the factors negatively affecting investor sentiment in recent months.

However, the impact may be much worse. The risk of debt default in the private sector has certainly risen. If defaults were widespread, some banks might come under pressure too. We believe that the risk of a systemic banking crisis is small given the wide-ranging reforms and the process of consolidation that the sector has undergone since the 2001 devaluation, but further bank failures cannot be ruled out. The recent interest rate rises and the fall in the lira will also push up the cost of servicing government debt, which, despite a steady decline from about 100% of GDP in 2001, was still high at just under 70% at end-2005. Some relief will come from the fact that the government has reduced foreign currency denominated and linked debt as share of the total debt stock, but the average maturity of government debt is still quite low at about 25 months as of end-May 2006.

So far the Turkish authorities have continued to use orthodox policy tools to try to dampen financial market volatility--interest rates, foreign exchange market intervention and fiscal measures. If these fail to have an impact and public opinion starts to swing against the government, it cannot be ruled out that they might resort to unorthodox policy tools such as short-term capital restrictions, especially with the next general election only about a year and a half away.

Source: ViewsWire Middle East
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