Danske: EM calming down, another crisis looming for TL
While we may well end the year with USD/TRY in the low-to-mid 7s, overshooting near term seems highly likely right now
Danske Bank research team joined other notable financial institutions , such Toronto Dominion Securities in issuing a stern warning to its investors about a currency crisis in Turkey. “USD/TRY bid as TRY is on the verge of yet another FX crisis; TRY needs higher rates or that broad EM sentiment turns strongly”.
We offer excerpts from its monthly EM report
In general, data seem to be coming in on par with our base case of a deep recession in Q2 followed by a gradual rebound in H2. Notably, our view of stabilisation and mild strength across CEE in RUB, PLN, CZK and marginally HUF also appears to be playing out. However, TRY is going down a path where it could be flirting with yet another currency crisis within months.
USD/TRY spot might be going down an exponential path, as the central bank continues to lower nominal interest rates and it has burnt around one third of its gross FX reserve since March with this now standing at USD53bn, down from USD78bn in early 2020. The inflation outlook is what sets the market and the central bank (TCMB) apart, with the latter seeing a strong tapering of inflation pressures over the coming month.
While this may be a fair account of inflation-FX dynamics for developed economies, it is a rather shaky assumption in a high-inflation country. Indeed, when inflation is low (typically the case in DM), commodity prices are set to drive headline inflation; to some extent this may then spill into wage growth and thus core inflation. However, when inflation is high (such as the US in the 1980s, Turkey today, or Argentina), it is not commodity prices that matter.
Instead, high inflation becomes embedded in expectations and wage formation and thus ends up much stickier. In order to curb CPI, a very deep and prolonged recession will often be required.
As such, it is essentially an erosion of the bargaining power for workers that is needed. In the Nordics, where union power is very strong (e.g. Sweden), this takes quite some time. However, in the case of Turkey, union power is minimal. Thus, if the recession is deep enough, it is not a problem to keep cutting rates because inflation will roll over by itself.
However, at the moment, the Turkish central bank seems increasingly to be front-running all of this. At this stage, it is not at all obvious that CPI will turn lower – but interest rates most surely will if recent central-bank actions are anything to go by. That leaves the central bank having to fight capital outflows to stem the TRY decline and mounting inflation pressure. At this point, in our view, we just need a small push in the wrong direction to lean into an outright currency crisis.
In sum, for a country like Turkey, the best way to ensure a stable currency is to aim for CPI stabilisation in the first part of a recession; this is in turn vital for the central bank in order to maintain financial stability. Only after a stable inflation path is ensured, lowering interest rates is a viable path. It goes without saying that the current Turkish path looks very unstable and we see a high probability of a currency crisis in coming months. That said, the TCMB strategy may still prove successful if broad EM sentiment turns strongly positive and the broad dollar starts declining. However, we do have our doubts when/if this will happen. While we may well end the year with USD/TRY in the low-to-mid 7s, overshooting near term seems highly likely right now.
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