Why the Turkish State could be "On its Way to the IMF"

-TRY pares loss following Qatar aid and CBOT intervention measures.

-But causes of crisis remain in place, leaving TRY vulnerable to losses.

-Without change in government policy, new record lows and IMF await.

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The Lira rose sharply for a second consecutive session Thursday and has now reduced its 2018 loss by almost half but the currency remains vulnerable to renewed losses and some analysts are claiming it is only a matter of time before the Turkish state is forced to go cap in hand to the International Monetary Fund.

Turkey's Lira has whittled an 82% 2018 loss against the US Dollar down to a -56% decline in the last week, thanks largely to intervention by the Central Bank of the Republic of Turkey (CBOT) and a generous aid package from the Qatari government that was unveiled on Thursday.

The CBOT injected around $10 billion of new "liquidity" into the financial system this week and has sought to curtail speculative currency trading activities among institutions, which helped stem the collapse of the Lira.

"This week, BRSA began by limiting the amount of FX swaps and similar instruments a bank can hold to 50% of regulatory capital; the ratio has since been halved to 25%. This measure is a kind of restriction on lira short positions," says Tatha Ghose, an analyst at Commerzbank.

That was followed Thursday Qatar Emir Sheikh Tamim's visit to Turkey, which saw the Emir announce a $15 billion package of foreign direct investment in the country. This is significant because it is an investment package, rather than a loan, that will go some way toward plugging the $65 billion Turkish current account deficit for a short time.

"Turkey's external financing gap automatically keeps adding to foreign debt every year. But even if the level of this debt was held constant (in USD terms), the ratio to GDP would be skyrocketing anyway. One result of constant FX depreciation is that Turkey's GDP has been shrinking in USD terms," adds Ghose.

The USD/TRY rate rose from 1.15 in September 2008 to a record high of 7.11 this week, which represents a significant devaluation of the Lira. On average, the USD/TRY rate has risen 61% each year since the financial crisis.

This year's run on the currency was brought on by an escalating dispute between Ankara and Washington and fears of what a politically compromised central bank might mean for the currency and economy further down the line.

While a recurring theme, the implications of the currency crisis are serious because it means Turkish borrowers' foreign currency debts and interest payments have almost doubled this year. Only a sharp rise in interest rates at the central bank will be able to stabilise the currency on a sustainable basis.

But this looks a distant prospect after President Erdogan told a rally of supporters at the weekend that “If we don’t minimise this interest rate, it is a vehicle of exploitation that will make the rich richer and the poor poorer.” It is President Erdogan's continued interference at the central bank, among other things, that broke the camel's back this year.

"Something has to give. If the government continues to pursue the policy mix of recent years — namely to boost growth through fiscal spending and resist a tightening of monetary policy despite rising inflation — the road to the IMF will be unavoidable," says Per Hammarlund, an emerging market strategist at Skandinaviska Enskilda Banken (SEB).

Hammarlund, like many others, says Turkey's economy needs "sharply higher" interest rates, less government spending and a support package for troubled sectors such as construction, retail and banking.

A credible commitment to central bank independence is also key but even then, to road to recovery would be long and bumpy, while significant risks to the Lira would remain in the short term.

"Erdogan and the Turkish authorities have shown few signs of being prepared to change course, either in its approach to the US or its economic policy. As a result, we expect the TRY selloff to resume, potentially triggered by additional sanctions on Turkish government representatives or a fine on Halkbank for violating sanctions against Iran," Hammarlund says.

Hammerlund and the SEB team forecast the Lira will continue to rise in the short term due to support from the central bank and aid packages from the likes of Qatar, China and Russia. But once it does eventually resume its decline, the subsequent depreciation will take it into uncharted territory once again. They predict a USD/TRY rate of 8.80 later this year.

"None of the measures announced by the authorities so far will likely suffice to stem this crisis," says Commerzbank's Ghose. "We reiterate our stance that either the FX market will develop in a manner which will force the central bank to hike rates sharply or introduce more systemic capital controls, which will go beyond simple risk management. But if such measures are not introduced, we see the present calm in the lira as temporary."

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