The Turkish central bank's recent move to raise interest rates is a much-needed step in the right direction to help an economy that, albeit very attractive to foreign investors, is also extremely vulnerable to global economic shocks, and has suffered greatly from the general reticence investors have had and continue to exhibit toward emerging markets.
While some argue that the interest rate should have been raised much earlier, the Turkish central bank's moves has nevertheless acknowledged the higher premium investors have been demanding to hold Turkish financial assets, said Paul Rawkins, sovereign analyst covering Turkey for Fitch Ratings in London. Also, Turkey's vulnerability to short-term capital outflows, which is its biggest problem, is reduced, he added.
Interest rate hikes could help to stabilize the currency, Rawkins said, and reduce pressure on Turkey's inadequate international reserves, while a weaker Turkish lira could speed up current account adjustment.
However, Turkey is also overly reliant on short-term capital, a dependence that together with its large current account deficit has contributed to its external vulnerability, Rawkins said, adding as risk averse investors have been selling their Turkish holdings and backing out, this is proving problematic for the nation. So much so that despite its inclusion in the MINT group of countries (the others are Morocco, Indonesia and Nigeria), which are touted as being the next big global economic story, some analysts and investors have a rather dim view on Turkey in the immediate future.
"The Turkish economy was fueled by very fast credit growth, which partly explains the current account deficit," Rawkins said. "Although the economy had successfully avoided a bust in 2011-2012 thanks to fiscal strength, monetary policy tightening and a reasonably strong banking sector, recent rate hikes will dent domestic demand and could renew concerns about an economic 'hard landing' in 2014."
In the years leading up to the 2008 financial crisis and even after that, Turkey depended heavily on all forms of cross-border borrowings, said Alec Moseley, a senior portfolio manager based in Schroders' New York office, and the extremely rapid growth in the domestic consumer and corporate sectors has been fueled by debt.
"One of Turkey's greatest vulnerabilities lies in the corporate sector, because two-thirds of all credit growth in the past decade has happened there," Moseley said. "As such, most Turkish corporates are running a large, net-short foreign exchange position, which means their foreign exchange liabilities are greater than their assets and this makes them vulnerable to exchange rate weakness."