The Turkish turnaround: How the central bank's bold actions could reshape investment landscape

Al-Monitor Pro members

Piero Cingari

Financial analyst

Sept. 6, 2023

The Central Bank of Turkey raised interest rates to 25% to combat inflation, delivering the fastest rate-hike cycle over two decades. While recent economic indicators show a mixed picture, Turkish assets have displayed strong performance, signaling renewed investor confidence. Achieving currency stability is essential to attracting foreign capital inflows and advancing domestic de-dollarization efforts. 

Scenario 1: Turkish Lira finds stability as high interest rates drive de-dollarization and attract foreign capital 

Governor Erkan's bold interest rate hikes mark a significant departure in the Central Bank of Turkey's strategy, demonstrating a resolute stance against inflation. 

Interest rates now at 25% aim to stabilize the currency. Initially, the Turkish Lira strengthened by 5%, but later retraced some gains. 

Short-term government bonds and bank deposits now offer returns exceeding 20%, a rarity among G20 economies. This could potentially lure hot money flows back into the local-currency government bond market if currency stability prevails, reversing the trend of mass exodus during recent years. 

Notably, 40% of bank deposits in Turkey remain in foreign currency. With the central bank's recent call on commercial banks to raise lira deposit rates, there's a chance for Turks to shift to competitive Turkish Lira accounts, possibly reversing dollarization. 

Rising foreign capital inflows into Turkish assets and bank deposits are expected to gain momentum, improving the financial account balance and potentially alleviating balance of payment pressures, especially if the current account weakens post-tourism season. 

The yield to maturity on dollar-denominated Turkish sovereign bonds, over 8%, can attract high-yield investors. Orthodox policies can drive this yield to the 7% average for emerging market dollar bonds.  

Scenario 2: Brief lira stability gives way to renewed depreciation amidst economic slowdown, foreign outflows 

In this alternative scenario, the lira may briefly stabilize but then face renewed depreciation due to ongoing economic challenges and persistent inflation. 

Factors such as Germany's stagnant economy (Turkey's key trade partner), declining domestic consumer confidence and a global manufacturing slowdown could lead to a more severe decline in Turkey's economy than expected. 

Turkish policymakers have often relied on the devaluation of the lira to shoulder a greater share of the required economic rebalancing. 

The end of the tourist season and expected debt maturities between October and December could strain the balance of payments, potentially reversing the positive trend in foreign exchange reserves. 

Turkish residents may need to keep a significant portion of their bank deposits in foreign currency, possibly sustaining or increasing the structural dollarization rate. Exchange rate pressures might deter foreign investors from Turkish assets. 

Piero Cingari is a financial analyst and writer who has worked as a fixed-income, FX and commodities analyst in the asset management and brokerage industry. Throughout his career, he has covered and analyzed economic and financial developments in Turkey, Egypt, and the Gulf countries. Piero is particularly interested in how major macroeconomic trends influence financial markets and how global geopolitical events may affect the economy of the MENA region.