Türkiye’s Central Bank takes steps to transition from lira deposit scheme

Surprising interest rate hike left market watchers puzzled
Türkiye’s Central Bank takes steps to transition from lira deposit scheme
Turkish lira (Photo Credit: Reuters)

Market observers suggest that the recent introduction of new regulations by Türkiye’s Central Bank (TCMB), aimed at phasing out an expensive deposit scheme intended to bolster the Turkish lira, is expected to encourage banks to expand their government bond portfolios. This move would consequently aid in financing the significant budget deficit the country currently faces.

The central Bank recently announced that the regulations implemented on August 20th are aimed at phasing out the FX-protected deposit scheme, which was initially introduced in December 2021 as an emergency measure to stabilize the declining Turkish lira. The scheme, also known as KKM, provided compensation by the state to depositors who converted their hard-currency accounts into lira deposits, covering any depreciation beyond the interest earned. The central bank’s objective now is to gradually transition KKM depositors to regular lira accounts, and banks that fail to meet the transition targets are required to purchase additional low-yield government bonds.

Following a surprising interest rate hike by the TCMB, many market watchers have been left with numerous questions. They seek to decipher the implications and signals provided by this unexpected move for future monetary policy decisions.

Read more: Türkiye seeks to scrap lira protection schemes, sparks banking sector concerns

Transition strategy

The KKM scheme aimed to prevent a surge in dollarization. It was implemented due to Central Bank rate cuts under President Erdogan’s direction. This was done despite high inflation. Currently, KKM deposits have reached around $124 billion. These deposits account for approximately 26 percent of all Turkish bank deposits.

Inflation is projected to reach 70 percent by year-end. Convincing KKM depositors to shift to regular lira deposits with low yields appears impractical in this context. Instead, banks are expected to opt for government bonds rather than raising lira deposit rates.

Some financial experts suspect that the new regulations have dual intentions. They believe that the regulations aim to use banks to finance part of the budget deficit. It is speculated that the goal is not solely focused on ending the KKM scheme. Ankara may leverage banks’ profitability in recent years to tolerate holding more low-yield government bonds.

The government’s strategy regarding the transition of KKM deposits and the potential conversion to hard currency remains uncertain.

Surprising rate hike

TCMB surprised the market by implementing a significant interest rate increase of 750 basis points, taking it to 25 percent.

The move to increase interest rates was three times larger than anticipated. This unexpected decision had a positive impact on the Turkish lira. As a result, the lira appreciated by as much as 7 percent.

The substantial increase in Türkiye’s interest rates has once again captured the attention of foreign investors, who are now considering reentering the Turkish asset market for investment opportunities.

According to Reuters, Türkiye’s top officials are reportedly undertaking two crucial measures to counter the prolonged decline in foreign investment. They intend to release a comprehensive economic program in September, aiming to reduce uncertainty. Additionally, they plan to initiate meetings with foreign investors to foster engagement and discuss potential investment opportunities.

Investor roadshow

Just two days ago, Reuters disclosed that Türkiye’s finance minister, Muhammed Simsek, is scheduled to commence an investor roadshow on September 19th. This roadshow is scheduled to take place at the headquarters of Goldman Sachs Bank in New York. It will provide an opportunity for potential investors to engage with Turkish officials and explore investment prospects. The event aims to showcase Türkiye’s economic potential and attract foreign investment.

The elevated interest rate reflects Türkiye’s preparedness to depart from unconventional policies as part of its efforts to combat the nearly 50 percent inflation rate.

Despite the intention of the resolution to provide support for the Turkish lira, the currency experienced a significant decline. This decline occurred following the adoption of the decision.  At the time of writing, the Turkish lira stands at 26.60 per dollar.

Positive territory

Goldman Sachs strategists emphasized a crucial requirement for Türkiye’s currency. They highlighted that the currency needs to become appealing to interest traders. To achieve this, a clear commitment is needed. This commitment should focus on bringing real interest rates into positive territory. They regarded the recent decision as “certainly a more effective step in this direction than the previous incremental approach.”

The economists at the bank noted that they are starting to witness initial indications of a tighter monetary policy taking effect throughout the system. This has resulted in a notable improvement in the current account, which could alleviate pressures on foreign currencies. However, they cautioned that certain macroeconomic precautionary measures still need to be addressed, and inflation continues to remain high, posing risks.

Turkish President Recep Tayyip Erdogan (Photo Credit: Reuters)

Interest rates unchanged

Türkiye’s Central Bank maintained the interest rates unchanged in the meetings held in May, April, March, January, and December. This decision came after the conclusion of the easing cycle, which President Recep Tayyip Erdogan had advocated for, aiming to reduce interest rates to below 10 percent, despite the escalating inflation. However, there was a reduction of half a percentage point in the February meeting as part of the measures taken by the country to support the country’s recovery from the impact of a significant earthquake.

Just recently, Erdogan stated that the high inflation in the nation is only temporary and indicated that the government is actively engaged in discussions regarding measures to address the increasing cost of living.

Earlier this month, Simsek made a commitment, stating that annual inflation is expected to start decreasing from mid-2024 due to the positive effects of the country’s monetary policy stance. However, it is noteworthy that Turkey’s inflation climbed to 47.8 percent in July.

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