Key takeaway – Despite declining reserves and increased interest rates, Turkey is unlikely to suffer a market-crash over the next 12 months.
Since the July 2016 coup attempt, the reserves of the Central Bank of Turkey’s (CBRT) declined. Gross international reserves declined by 14 percent (by USD 14.5 bn, from USD 104.7bn to USD 90.2bn – Figure 1). Net international reserves – gross reserves minus short term foreign exchange (FX) debt – also declined (by USD 3.7bn, from USD 33.7bn to USD 30bn – Figure 2).
Based on the International Monetary Fund’s (IMF) criteria of international reserve adequacy, CBRT’s reserves are low (Figure 3), due to: a) high short-term FX-denominated corporate debt (as of Q2 2017, USD 79bn, approximately 10 percent of GDP); and b) a high share of FX deposits (as of Q2 2017, 42 percent of total deposits).
Figure 3: Turkey: low reserves, according to the IMF
Since July 2016, the CBRT increased the average cost of funding by 380bps, in response to the Turkish Lira (TRY) depreciation. In particular, the CBRT: a) hiked its one-week repo rate (policy rate) by 50 basis points (bps), from 7.50 to 8.00 percent; b) hiked its overnight (O/N) lending rate by 25 bps (from 9.00 to 9.25 percent); c) hiked its late liquidity lending rate by 175 bps (from 10.50 to 12.25 percent); and d) kept stable the O/N borrowing rate at 7.25 percent (Figure 3). As a result, the interest rate corridor (the difference between the lowest and highest policy rate) rose from 200 to 500 bps. The CBRT weighted average cost of funding (the de facto policy rate in Turkey) rose from 8.20 to 12.00 percent. In the same period, the TRY depreciated by 22 percent against the United States dollar (USD, Figure 4).
Why did it happen?
Between the July 2016 coup attempt and the April 2017 referendum (focused on presidential system changes), the CBRT has actively used monetary policy to reduce volatility. The volatility was created by political tensions, combined with the start of the tightening cycle in the US (three hikes since July 2016, for a total of 75 bps). As a result, the Turkish economy suffered: 1) portfolio outflows (Figure 5); and 2) an increasing dollarization of deposits (Figure 6). In the face of the rising demand for USD and market volatility, the CBRT employed both reserves and interest rates to stabilize the TRY and the markets. On the reserve side, the CBRT: a) used reserves to meet some of the demand for USD; and b) between February and June 2017, allowed interest payments on USD-denominated export credits it had granted to be paid in TRY (rather than USD). On the interest rate side, the CBRT: a) hiked policy rates—making carry trade more attractive—to stem some of the outflows; and b) increased the interest rate corridor to create room for interest rates adjustments, if needed.
What will happen next?
Despite the external financing risks, the Turkish economy will continue to be resilient. In the short term (next 12 months), the Turkish economy is unlikely to face BoP crisis. a) The economy is endowed with automatic stabilizers, as: i) higher global growth would reduce global liquidity but benefit the export sector; ii) lower global growth would increase global liquidity, hence inflows into emerging markets (EMs), including Turkey – via carry trade; b) foreign companies are unlikely to divest from Turkey, given: i) the large size of its market; ii) the consumption-driven structure of the economy; and iii) the GDP growth levels are still above developed markets (DM) GDP growth rates; c) imports are likely to remain stable, as oil prices will stay range-bound; and d) exports are likely to hold up: embargoes are unlikely, due to Turkey’s geostrategic importance and its key role in the EU’s supply chain as an intermediate good exporter.
Turkey is unlikely to face a market turmoil that will require the CBRT to use its reserves. In the short term (next 12 months), a market crash (a fall of more than 10 percent in just one day, or 40 percent from the 52-week high over 150 days) is unlikely. Going forward, higher portfolio inflows will reduce the demand for USD, due to: a) decreasing political volatility; b) a slower pace of Fed hikes; and c) increased TRY stability. Also, the exemptions granted by the CBRT to repay USD-denominated export loans in TRY expired in June, de facto increasing CBRT’s future USD income, and hence reserves.
Even if a market-event were to materialize, the CBRT can deploy reserves … The current level of reserves — USD90bn gross and USD30bn net — suffice to stabilize panicky markets: in January 2017, when the TRY depreciated from 3.52 to 3.77, the CBRT only required USD5bn of reserves to meet FX outflows and stabilize the currency.
… and increase interest rates. The CBRT can also use its interest rate tools. In January 2014, when the TRY depreciated from 2.01 to 2.33 against the USD, the CBRT stabilized the currency by hiking its policy rate by 550 bps (from 4.50 to 10.00 percent). As headline inflation has declined from 11.7 percent in April to 10.9 percent in May, policy rates are expected to remain stable.
We thank Aslı Savranoğlu Seren for her comments and suggestions. All errors are ours.
 Since July 15, 2016, the standard deviation of Borsa Istanbul was 8.7 percent (compared to a 5-year average of 7.7 percent).