Turkey's dangerous game risks financial chaos

Turkish President Recep Tayyip Erdogan
Mehmet Ali Ozcan | Anadolu Agency | Getty Images
Turkish President Recep Tayyip Erdogan

The Turkish government is playing a dangerous political game that risks hitting the country with a full-blown currency crisis and ratings downgrade, experts warn.

Over the past week, Turkish President Tayyip Erdogan's administration has lashed out at the central bank, urging it to aggressively lower interest rates to shore up economic growth ahead of general elections in June. The political pressure has troubled investors, sending the lira to an all-time low of 2.6290 per dollar on Thursday, the third straight day of record declines.

Erdogan's demands come after the Central Bank of the Republic of Turkey (CBRT) lowered benchmark rates last month, its second cut since December. While the CBRT has been under pressure to ease policy for years, markets are worried recent scathing attacks could spell the end of the central bank's independence.

"The CBRT's dovishness has coincided with a period of intense political pressures, which has only bolstered the market's skepticism regarding central bank independence and credibility," stated Barclays analysts in a note.

"There's nothing wrong with a collaborative policy between government and central banks, but this type of confrontation undermines the CBRT's authority. It's also counterproductive as it doesn't translate into macro stability," said Vishnu Varathan, senior economist at Mizuho Bank.

Turkish Prime Minister Ahmet Davutoglu attempted to reassure investors on Thursday, stating that the country's central bank remains independent: "There is no need to worry about Turkey's institutional set-up," he told the Council on Foreign Relations in New York.

Lira in freefall

The market has taken a dim view of Erdogan's encroachment into monetary policy and the risk is that he could stir a currency crisis, said Kathleen Brooks, research director at FOREX.com in a note on Thursday. All eyes are now on what the central bank does at the next policy meeting on March 17th.

"It seems like the market is only interested in one direction when it comes to the lira, and that is lower," Brooks said. "If the central bank governor does resign in the coming days, or bows to pressure from the government, then this could trigger another leg higher for USDTRY."

Turkish lawmakers trade blows in parliament
Turkish lawmakers trade blows in parliament   

Barclays agreed that the lira's selloff will only get worse if the central bank does yield to Erdogan: "The potentially aggressive interest rates cuts would keep real rates subdued, even though inflation is expected to fall over the coming months, eroding the currency's attractiveness."

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With losses of 10 percent against the greenback since January, the lira is one of the world's worst-performing currencies this year.

If it continues to weaken, Turkey's gross external debt will become more expensive to service. "Although overall public debt levels remain low at 36.6 percent, external debts denominated in foreign currency have risen, which leaves the country vulnerable to a currency crisis," Brooks continued.

Downgrade on the cards

Continued confrontation between the government and central bank increases the risks of Turkey losing its investment grade status over the next few months, according to Barclays.

"The pressures on the CBRT to cut interest rates will likely heighten concerns about checks and balances, policy predictability and broader political risks in Turkey, which had been cited as source of downward pressure on Turkey's rating by both Fitch and Moody's," the bank said.

Consequently, it recommends investors take a more cautious approach toward Turkey despite the country being a major beneficiary of falling commodity prices.