High Turkish interest rates offset lira’s risks

ISTANBUL – Defying expectations, Turkey’s lira currency continues to strengthen as some of the highest interest rates in emerging markets attract investors, but the large number of foreign buyers also makes it more vulnerable to investor mood swings. From the depths of a mini-crisis last June, the lira has strengthened some 25 percent, despite a large current account deficit, slowing growth, a partial suspension of European Union entry talks, anxieties about this year’s elections and persistent inflation. Lira investors all but brushed off last Friday’s data showing January monthly inflation at 1 percent, three times as high as forecast. This was in stark contrast to last May when April inflation came in three times as high as expected but sparked a steep market sell-off. Since then, however, monetary policy has been sharply tightened. Investors now enjoy benchmark interest rates of 17.5 percent – some of the highest in emerging markets and 4.5 points higher than in Turkey’s closest rival market, Brazil. «We’ve actually seen a pickup of carry trade,» Lehman Brothers economist Tolga Ediz said, referring to the practice of borrowing cheap currencies like the yen to invest in higher yielding currencies. «So in that environment… Turkey stands out as a risky but worth-the-risk place,» he said, putting returns at about 1.5 percent a month. «Most people say I’m paid for the risk I take in Turkey.» That could explain why the inflation data went down so well, leaving the lira around 1.4000 to the dollar. Inflation should undermine a currency by eroding its purchasing power, but if the currency’s strength comes from foreigners in search of yields, higher inflation can be positive as it means rates are likely to stay higher for longer. «They’ve (the central bank) got good reason to stay on hold now… that implies carry and that will keep the appreciating pressure on the lira,» said Goldman Sachs’s Ahmet Akarli. Not everyone is convinced. Schroders’s head of emerging market debt Geoff Blanning, whose investment time frame is six months to a year, says the lira is one of the least attractive emerging currencies because of the current account deficit. «The most surprising thing to us is that since the crisis last year investors seem to have increased their exposure… while there hasn’t been a major change in economic policy. So it seems still a recipe for trouble,» he said. Central bank data show foreign portfolio investment in the third quarter of 2006 at $70 billion compared with $63 billion in the second quarter – when the sell-off took place. Yields vs politics January’s year-on-year inflation rise of 9.93 percent was more than twice the central bank’s 4 percent end-2007 target and analysts say one risk is that bond investors will balk at continued sharp price growth, which would spill over to the lira market. Some also see a risk of getting burned by central bank intervention at around 1.4 lira per dollar, seen by markets as a key level. Early last year the central bank intervened to weaken the lira amid exporters’ concerns. The central bank’s latest survey of expectations points to a year-end lira rate of 1.55 to the dollar, a view shared by Akarli and Ediz. For now, investors say foreign ownership of bonds is higher than it was in May last year, a sign high yields are encouraging buyers to turn a blind eye to both economic and political risks, such as presidential and general elections in May and November this year. Parliament chooses a president in May, which is likely to stir tension between the religious-minded ruling Justice and Development Party (AKP) and secularists, who oppose an AKP candidate on the grounds he might try to reform aspects of the secular state. Prime Minister Recep Tayyip Erdogan has refused to say whether he will run and investors fear that if his party uses its majority to elect him or a similarly divisive candidate it could be punished in general elections in November. That could usher in a weak coalition government, which investors see as a major risk. While local investors are concerned about the impact of elections on politics-sensitive markets, foreigners are calmer. «Despite the obsession with the political noise, the fundamentals of the country remain robust,» said Morgan Stanley economist Serhan Cevik. «There’s a dichotomy between foreign perceptions and domestic perceptions.» For now that works in the lira’s favor, particularly at the start of the year when investors are taking positions. But if interest rates in developed markets rise, shrinking the differential between high and low risk assets, and risk appetite shrinks that large foreign presence will undermine Turkish markets. «The main risk is the global environment,» Akarli said. That, and how lucrative the carry trade remains, will determine how sensitive foreigners become to politics. «Foreign investors’ opinion on the politics can change according to where US bond yields go,» Lehman’s Ediz said.