CBRT ups the pressure on banks as the lira falls and Turkish inflation continues 

The objective of Carraighill research is to understand the environment within which our companies operate in as much detail as possible. Our analysts can then undertake detailed fundamental work on specific companies, with a clear understanding of the ecosystem. Inflation and monetary policy, as well as the ultimate direction of the Lira currency (given the high level of FX loans) has clear implications for companies within our investment universe with exposure to the region.  

Turkish officials have opened a new avenue of unorthodox monetary policy this month by starting to query large volumes of legitimate FX transactions, in some cases worth as little as USD 1m, putting pressure on employees of domestic Turkish banks not to process them.  

This comes as the CBRT attempts to slow the trend toward dollarization and inflation in the country. For context, 57% of bank deposits in Turkey are already held in FX denominated accounts.  

The Origins of Turkish Inflation 

The fall in the lira versus major currency pairs began when the CBRT implemented another unorthodox policy: cutting interest rates in the face of high inflation. This policy springs from President Erdoğan’s bizarre belief that high interest rates cause high inflation. The reasoning goes something like this: 

  1. High domestic rates attract foreign capital, 
  2. Domestic banks lend the newly injected capital out, and 
  3. This spending puts pressure on prices. 

This is, of course, wrong. Higher rates are disinflationary in at least two ways. First, higher rates encourage saving, not borrowing. Second, higher rates have a wealth effect. The appropriate discount rate at which future cash flows are valued is now higher, which makes those assets that are predicted to produce future cash flows – bonds, stocks, REITs – worth, in some cases, substantially less now, especially if the bulk of the cash flow is predicted to arrive only in the distant future. The resulting fall in asset prices from higher rates leads to weaker balance sheets for consumers and less spending as a result. This brings inflation down. 

Surging Turkish Inflation 

The results of the policy have been as poor as the reasoning behind it. Turkish inflation is now running at 70% YoY in April and shows no signs of abating. Everyday necessities have been hit even harder with energy inflation running at 80% YoY and food and non-alcoholic beverages increasing at an unsustainable 118% YoY. 

Soaring inflation has put political pressure on President Erdoğan, with his party the AKP recording its lowest level of support in 5 years. As next year’s election comes into focus President Erdoğan has been passing several populist measures intended to improve both his standing and that of his party. For instance, he raised the minimum wage by 50% at the start of the year in a bid to offset the hit of inflation on the working class. Changes to the minimum wage are especially impactful in Turkey, a country where minimum wage earners make up 40% of the workforce. The irony is that this policy, though it is probably only meant as a stopgap, is itself inflationary. 

Resolving Turkish Inflation 

The CBRT has tried several other unusual policies aimed at quelling inflation and supporting the lira. For instance, they attempted to lure citizens back from saving in dollars to lira by introducing a new type of bank account. The new account would compensate savers for any loss if the lira declined in value against the dollar more than the interest rate offered by the domestic banks would offset. So, if you would have been better off holding dollars instead of saving in lira at the current rate, then the Turkish treasury would be on the hook for the difference. While coinciding with a temporary strengthening of the lira, the policy has at best only partially helped to reverse the trend of dollarisation. The initial strengthening was primarily driven by large purchases of the lira by the CBRT at the time of the announcement.  

The catalyst for the most recent lira slide – down 4% against the dollar since the start of May – has been the recent rate increases and hawkish guidance provided by major central banks. This, combined with the extremely high Turkish inflation is opening a chasm in real rates offered by Turkey and some major economies. For instance, the gap between the real rate of return offered in the US and Turkey was a staggering 47% in April. The search for a safer currency to save in alongside the carry trade predictably leads savers to move their lira into dollars/euro and out of the country to earn at the higher real rates offered elsewhere. 

The crisis in Turkey will not be fixed by holding up small corporate outflows of lira. In fact, it won’t be fixed by any of the newly implemented unusual monetary policy or recent populist-inspired fiscal spending. The problems in Turkey started when unorthodox monetary policies were introduced and they will only end when those policies are retired.  

So how do we make money for our clients from this analysis? 

The primary objective of Carraighill is to undertake deep fundamental analysis on individual companies. However, to do this, one needs to have a very deep understanding of the environment within which these companies operate. This helps us have constructive conversations with Management and generate more thoughtful insight. This is an exhausting process, but a core part of what we do. In this particular case, it influences our thought process on the domestic banks in Turkey and international banks with a large presence in the country (BBVA in particular). 

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