Wider trade deficits
A policy preference to keep the nominal exchange rate stable amid deeply negative real rates, along with fiscal and credit stimulus, have led to a notable widening in the trade deficit since the start of the year: The trade deficit was at record-high levels both in January and February, driven by strong imports, gold imports in particular, and a slowdown in exports that started before the earthquake hit on February 6. The sum of the trade deficit in January-February stood at US$26.3 billion, US$8 billion higher than in the same period last year despite a slight decline in energy imports (to US$15.5 billion from a total US$16.6 billion).
Quality of external deficit financing very low
More importantly, almost all of the current account deficit in January (US$9.8 billion) was financed through reserves, as inflows from errors and omissions, overseas deposits and loans stopped. Preliminary data for March suggest a notable decline in gold imports to US$1.7 billion, probably reflecting the new regulations regarding trade in gold. This along with a decline in energy imports to US$6 billion drove a decline in the monthly trade deficit to US$8.6 billion, still high compared to historical averages.
CBT bleeds FX reserves, despite ample official inflows
The CBT’s gross FX reserves declined by about US$14.3 billion from their December peak of US$85.6 billion as of March 24,2023: This is despite US$5 billion deposits from Saudi Development Bank which seem to have entered CBT accounts around March 10-13. Gold reserves reached US$53.4 billion, thanks in part to a rise in gold prices, and supported the level of total gross reserves at around US$125 billion. According to our calculations, usable liquid reserves are around US$32.5 billion as of March 24, down from their high of around US$45 billion in mid-December.
With our current account deficit forecast of US$9 billion in February and around US$7 billion between March and May, the downward pressure on usable reserves is likely to continue in the absence of meaningful FX inflows, possibly declining towards the lows around US$21-22 billion observed last July before Rosatom transfers for the Akkuyu nuclear plant.
Exchange rate regulated by daily incentives and restrictions, rather than market forces
Amid credit expansion driven by state banks and widening in the budget deficit since the start of the year, policymakers stepped up their efforts to contain locals’ FX demand: The interest rate caps on FX-protected deposits (KKM), which were kept at 300bp plus the policy rate since their introduction, were removed, first for those that are converted from FX deposits on January 26,and more recently for those converted from Turkish lira accounts (Treasury-backed KKM). Moreover, the CBT passed a decree on April 1, which potentially allows for maturities shorter than three months for FX conversions to KKM. While average deposit rate on TRY deposits between 1-3-month maturities stand at 28.1% on average, some banks started to offer higher deposit rates of around 36% on KKM accounts following the removal of the caps.
While the simple ratio of TRY deposits (including KKM) to total deposits stands at around 58.9%, most banks have reached the 60% deposit liraisation target by the CBT and are trying to support KKM rollovers by offering higher rates to remain at the target.
Continued inflows to FX-protected deposits support the lira in the short term but impose challenges for adjustment post-election
Continued inflows to FX-protected deposits support the lira in the short term but impose challenges for adjustment post-election: Between January 13and March 24, the cumulative increase in KKM was US$14.7 billion. Most of this was likely converted from FX deposits, which declined by US$11.6 billion in the same period (unadjusted for parity).
The KKM stock has reached US$88 billion, 16.8% of total deposits as of March 24.
According to our calculations, around 70% of the current KKM stock has been converted from FX deposits, which implies potential FX demand at the end of maturity (3-month on average), especially if KKM is to be unwound as planned by the opposition. Another challenge related to KKM is its fiscal cost, which was around TRY 181.5 billion, 1.2% of GDP in 2022, with a TRY 92.5 billion direct cost to the Treasury and with an estimated TRY 89 billion loss borne by the CBT as implied by the CBT’s financial tables for 2022.
This cost could be much higher depending on the size of the KKM stock and potential FX adjustment post-elections.
Despite the rise in deposit rates, the pressure on central bank reserves and FX has led the CBT to take extra steps to contain firms’ FX demand. According to Bloomberg News on March 20, the CBT has instructed banks to sell FX at a higher rate to firms that have an FX surplus on their balance sheet as evaluated by the CBT.
We expect the CBT to continue to monitor locals’ FX transactions closely with a view to delay firms’ FX purchases where possible to keep the lira stable ahead of elections. This, in turn, implies pent-up demand for FX from corporates post-elections, which is another important policy consideration like the large KKM stock, which we look at in the next section.
We do not factor in a sharp FX adjustment pre-elections, but we see significant upside risks to USD/TRY in the short term: Given the strong policy preference for keeping the lira relatively stable until the elections, we expect increased scrutiny of locals’ transactions and possibly tighter liraisation regulations by the CBT. The recent decisions to increase the return of KKM and reduce its maturity give support to the latter view.
But the surge in the trade deficit amid expectations of a sharp FX adjustment post elections, a slowdown or potential reversal in errors and omissions inflows and potential portfolio demand for FX in response to election uncertainty pose upside risks to this view.
Against this backdrop of potential pent-up demand by firms, upcoming KKM rollovers and the decline in liquid reserves, we expect a significant adjustment in the nominal exchange rate in the short term post-elections: This adjustment is likely in all possible election outcomes but could potentially be more immediate in case of a change in political leadership as there would be an interim period until a new government is formed. There would likely be uncertainty regarding the implementation of current FX and liquidity operations during this interim period, which might mean increased volatility in FX and other market prices until a new economic management takes office and a macro policy framework is put in place.
Apart from this change regarding the short term, we stick to our previous view that the real exchange rate adjustment post-elections will depend on the macroeconomic policy framework that will be in place. That is, we see a smaller role for real exchange rate adjustment in case of a credible monetary tightening and progress on structural reforms, as domestic demand compression should help external rebalancing and external finance conditions should become more favourable over time, conditional on a tightening in country spreads.
Excerpt from Macro Trip Notes Ahead of Elections
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