Turkey’s economy will be hit hard by the Fed’s planned interest rate hikes

After US consumer prices rose 7.5% year-on-year in January, the Federal Reserve is expected to raise interest rates at its March meeting in a bid to contain inflation. While it’s unclear how aggressively the US central bank will raise rates, markets are expecting a hike of at least 25 basis points (0.25%).

The move, which will boost the US dollar, raises the specter of foreign funds flowing into US markets. For emerging economies, especially Turkey, expected rate hikes to contain inflation are bad news, but far from unexpected.

Most emerging economies have already taken several steps to weather the economic impact of potential Fed rate hikes, including their own interest rate hikes to preserve the value of their currencies and prevent the flight of foreign funds. .

But Turkey’s Central Bank has done the exact opposite, cutting interest rates by 500 basis points since September under political pressure, triggering an outflow of foreign funds – a process likely to be accelerated by interest rate hikes. the Fed. Turkish President Recep Tayyip Erdogan holds an unorthodox view that high interest rates lead to high inflation.

Finance and Treasury Minister Nureddin Nebati’s trip to London last week to showcase Turkey’s unorthodox economic model appears fruitless so far. Indeed, days after Nebati’s return, ratings agency Fitch further downgraded Turkey’s sovereign debt rating into junk territory, citing growing financial vulnerabilities. The country’s current account deficit reached $6.6 billion in November-December, with the annual current account deficit standing at some $15 billion. The deficit is expected to widen in January and will remain a problem for the country’s import-dependent economy in 2022.

The US Federal Reserve aims to lower inflation which has been fueled by supply bottlenecks resulting from the pandemic by gradually raising interest rates. Markets anticipate full rate hike will reach 100 basis points by July.

The European Central Bank (ECB) is also considering interest rate hikes, albeit less aggressively than the Fed. “The economic recovery cycle in the United States is ahead of that in Europe, so we have every reason not to act so quickly and so abruptly,” said Christine Lagarde, director of the European Central Bank ( ECB). Reuters. Financial markets expect increases of up to 60 basis points by the end of the year.

The Bank of England has already hiked rates twice since December, with markets expecting another hike after its next meeting in March.

Western monetary tightening has helped drive up interest rates globally, with many emerging countries trying to make their currencies more attractive to foreign investors. In Turkey, on the other hand, the central bank cut the rate to 14% with consecutive cuts since September.

This, in turn, accelerated the flight of foreign funds from the country. December alone saw a net outflow of $8.7 billion. The inflow of foreign direct capital of some $2.5 billion can be attributed to real estate purchases by foreigners.

In a bid to prop up the Turkish lira and curb dollarization, the government introduced a series of measures in December, including a state guarantee to compensate pound depositors in the event of a decline in the currency. Still, the backup seems to have inspired little confidence. Some 65% of individual deposits are still in hard currency mainly due to the continued distrust of the Turkish government. Moreover, the hard currency is still considered a safe haven for savings in a context of skyrocketing inflation, which probably climb to almost 60% in the next two months.

Turkey’s external debt, which has reached some $168 billion, coupled with expected Fed rate hikes, could trigger new demand for the US dollar, causing the lira to fall further.

By lowering Turkey’s sovereign debt rating Fitch cited several risks, including the possibility of greater instability ahead of the next election.

“The risk of further destabilizing monetary policy easing or stimulus policies ahead of the 2023 general election is high, and there is a high degree of uncertainty about the authorities’ policy reaction function in the event of a further episode. financial stress as political considerations limit the central bank’s ability to raise its policy rate,” Fitch said. Similarly, Standard and Poor’s and Moody’s downgraded Turkey’s ratings in December and September respectively.

Edward N. Arrington