Shake-up in Turkey spurs lira rally

Turkey rattled investors with surprise changes in its economic management over the weekend after the lira hit new record-low levels against the US dollar on Friday. The currency declined to as low as 8.58 versus the US dollar.

Turkish President Recep Tayyip Erdogan sacked the head of the Turkish Central Bank (CBRT) Murat Uysal later that day and replaced him with former finance minister Naci Agbal, a close ally.

Uysal was appointed by Erdogan himself just 16 months ago, when Erdogan dismissed Uysal's predecessor Murat Cetinkaya due to his displeasure that Cetinkaya hiked rates to 24% to support the lira and refused to cut them.

Following Agbal's appointment, Berat Albayrak, the son-in-law of president Erdogan, stepped down as Turkey's finance minister on Sunday citing health reasons.  

Despite the dramatic events and uncertainties over who would take over, markets welcomed the announcements.

Lira rebounds

The lira rallied on Monday as much as 5% after the developments, even though it was not immediately clear whether Erdogan had accepted Albayrak's resignation and whether a new finance minister would be appointed. Erdogan spoke at an event on Monday but did not comment on Albayrak's resignation.

The lira rebounded to 8.12 versus the dollar and 9.65 against the euro at 1358 GMT. Turkish lira is about 10% undervalued and has a "big appreciation potential" tweeted Robin Brooks, chief economist at the Institute of International Finance (IIF), adding "a clear policy signal" was needed.

Markets remain sceptical whether these developments mean a change of direction and seek more proof that independence and credibility of monetary policy will be restored.

Credibility test

In a statement released on Monday Agbal said: "The CBRT will decisively use all policy tools in pursuit of its price stability objective."

Agbal's statement raised hopes in the market and the lira rallied on expectations of a hike in the policy rate at the next monetary policy committe meeting on November 19. Now Agbal faces the challenge of stabilising the lira and restoring the credibility of the central bank.

"This unusual set of events could mark a shift towards orthodox policies, which would provide the lira with a much-needed respite," wrote Rabobank's senior strategist Piotr Matys. "That said, we and other market watchers have given Turkey the benefit of the doubt on so many previous occasions that this time it would perhaps be prudent to wait and see concrete steps before making strong conclusions whether Governor Agbal, in close cooperation with the Erdogan administration, will be able to restore the shattered confidence in the lira," Matys added.

Matys is not a lone sceptic. Commerzbank's Ulrich Leuchtmann wrote in a report that the immediate lira reaction should not "deceive" investors. "Turkish politicians and the central bank often managed to stabilise the TRY exchange rate short term," he said, adding: "However, that will not last long as the underlying problem is not tackled: the lack of independence and credibility of monetary policy."

The lira has lost around 30% of its value since the start of the year, while annual inflation has hit 11.89%.

Turkish central banks' efforts to stabilize the lira under Uysal by raising borrowing costs and adjusting liquidity, without resorting to outright policy rate hikes, proven to be ineffective as the currency hit series of record low levels against the dollar and the euro in recent months.

President Erdogan said last month that Turkey was waging war against a "devil's triangle" of interest rates, inflation and exchange rates, raising further concerns about the central bank's policy independence. Erdogan has repeatedly railed against raising interest rates.

Pressure intensifies

The pressure has been building on the CBRT to deliver an aggressive rate increase for some time as the lira hit a series of record lows.

"That pressure has now almost certainly intensified" wrote Jason Tuvey, a senior emerging markets economist at Capital Economics.

"At a bare minimum, Mr Agbal will need to raise the benchmark one-week repo rate sharply, probably by at least 400bp [basis points], which would take it to 14.25% and bring it in line with the average cost of funding," he said.

And Rabobank's Matys believes "an outright rate hike of a high magnitude is urgently required," adding that Agbal should raise the policy rate by at least 500 basis points this month.

Agbal also needs to shift to orthodox policy and affirm that the one-week repo rate will be the key policy rate and that there will be no further adjusting of monetary conditions through the rate corridor, according to analysts.

"Such moves would help to restore some of the CBRT's battered credibility and provide hope that it is taking the fight against inflation more seriously" said Tuvey.

However, it is still unknown who will succeed Albayrak. Adding to the uncertainty are concerns that even a substantial rate hike will not prove sufficient to put the lira on the path of a sustainable recovery if that is not accompanied by efforts to address Turkey's structural problems.