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In view of Morten Lund, Analyst at Nordea Markets, the sell-off in the TRY  and several other EM currencies  was triggered by the relatively sharp USD appreciation and the continued tightening of financial conditions in the US, but the list of fundamental and political risks in Turkey is much longer compared to many other EM countries and the reason why the TRY in recent days entered into a full-blown  currency crisis.

Key Quotes

“The biggest idiosyncratic reason why the TRY is bleeding from a fundamental perspective is the  elevated inflation.  Thus, the current 11% (y/y) inflation is decreasing the households purchasing power and leading to negative spill-over effects to the real economy in terms of a slowing private consumption and a burning housing market. Furthermore, soft indicators such as consumer confidence and PMIs are deterioating. The high inflation is a consequence of a too loose monetary policy with too low interest rates which has not supported the currency and thereby led to higher import prices and inflation. In turn, the too high inflation has resulted in the currency weakening further completing the  vicious circle.”

“The vicious circle can only be broken when the central bank choses to step in, hike the interest rate enough and restore its credibility.”

“While yesterday’s rate hike was a step in the right direction, the central bank’s more hawkish policy may be short lived as  Erdogan recently stated that he will be taking even more responsibility for monetary policy  if (when) he wins the snap presidential election 24 June.”

“Given Erdogan’s controversial statement that inflation will only fall when the interest rates are lowered, a more active role in the monetary policy would impose a great risk for the Turkish lira.”

“Another big issue for the Turkish economy is the  high current account deficit. With the recent rise in oil prices in mind (Brent oil up almost 22% in May in TRY terms, 46% YTD), the deficit will probably widen even further because Turkey is a big net importer of energy.”

“Pulling in the other direction, however, is the TRY depreciation as a weak currency generally improves export conditions. On the other hand, the weaker TRY also causes the deficit to become more expensive because Turkey has a big external finance need. Hence, the large amount of FX loans (mainly in USD) has turned into a bigger and bigger problem in recent years – especially in the corporate sector – resulting in the highest foreign debt exposure relative to GDP among the EM countries according to IIF.”