Lira stability key as Turkish central bank enters tightening cycle
* Central bank signals period of tightening
* Lira stability to underpin policy decisions
* Private sector has high level of foreign borrowing
ISTANBUL, July 29 (Reuters) - A need to defend the lira to fight inflation and to protect the balance sheets of a private sector with high levels of foreign borrowing means Turkey's central bank is likely to be in a tightening cycle for the foreseeable future.
Many economists expect the bank to raise its year-end inflation forecast of 5.3 percent when it releases its latest quarterly inflation report on Tuesday.
Annual loan growth, meanwhile, is running above 26 percent, close to double the central bank's target, with lenders financing that expansion mostly through foreign borrowing, heightening their vulnerability to a weakening currency.
The bank has already taken action. It hiked its overnight lending rate last week in response to capital outflows that have knocked the lira down as much as 9 percent against the dollar over the past few months. It signalled it would fight further depreciation by tightening liquidity rather than spending its reserves.
"For 2013 and beyond, exchange rate stability seems to be the overriding goal of the central bank," said Umit Ozlale, an economics professor at Istanbul's Ozyegin University who advised Turkey's central bank for almost 10 years.
"If it observes a depreciating lira, which would further worsen inflation dynamics and company balance sheets, it will announce extra policy tightening where the commercial banks will have to sell their forex holdings or lira-denominated bonds."
Such a move would increase the real interest rate on lira assets and help to support the local currency.
This does not sit well politically with Prime Minister Tayyip Erdogan, however.
Fearing an economic slowdown ahead of an election cycle starting next year, he has championed loose monetary policy and railed against a "high interest rate lobby" he sees as seeking to undermine Turkey's growth.
The central bank has nonetheless burned through more than $6.6 billion, about 15 percent of estimated disposable reserves, this year to try to defend the lira without raising rates. It has had limited success and cannot pursue the policy indefinitely.
Ample global liquidity, the lira's relatively low volatility compared with emerging markets peers, and low interest rates have prompted a private sector foreign borrowing spree.
But uncertainty over the outlook for the U.S. Federal Reserve's bond-buying programme and anti-government protests in Turkey during much of June sent the lira to its weakest ever on July 8 as capital flowed out of the country.
Turkish business, one of the pillars of support for Erdogan's AK Party, would have much to lose from a continuation of this.
The private sector's long-term foreign-denominated debt has almost quadrupled in less than a decade to $143 billion from around $37 billion in 2004. Around $84 billion of that amount belongs to companies outside the financial sector.
"The real sector should care about the forex risks on their balance sheets. To bet on currency appreciation or depreciation in the coming period is like gambling," Deputy Prime Minister Ali Babacan said last week. "You should hedge yourselves."
Turkey's low savings rate and high current account deficit - at 7.1 percent of GDP, its main economic weakness - makes it heavily dependent on capital inflows to finance that gap.
"The central bank never says it explicitly, but it is concerned that a volatile and weaker lira will make it harder to reach its inflation target and put further pressure on the private sector's forex liabilities," said BGC Partners Chief Economist Ozgur Altug.
"The private sector in Turkey has a relatively large short forex position. So far no Turkish companies have experienced any repayment difficulties as these companies have ample forex reserves and collateral abroad. But a weaker lira would pressure their bottom lines as they will have to record forex losses."
Telecoms firm Turk Telekom was one such example, announcing a 56 percent fall in net profit in the second quarter due to forex losses, despite a rise in sales.
But with Turkish banks and companies well-managed and willing and able to pay their liabilities, a gradual weakening of the lira should not create any systemic risk, according to Timothy Ash, head of emerging markets research at Standard Bank.
"I still tend to think if the lira weakened gradually over an extended period of time, and perhaps in line, or slightly more aggressively than other emerging markets central banks, then they would not be too unhappy," he told Reuters.