Turkey’s central bank needs to pay more attention to inflation and to restore its credibility through interest rate rises, the International Monetary Fund has said.

The criticism comes at a time when the country’s currency is also under strain amid fears that global economic turbulence will expose the vulnerabilities of Ankara’s domestic demand-driven economic boom.

On a week the Turkish lira fell to a record low against the dollar, a visiting IMF delegation called for the central bank to end its heterodox experiment with low interest rates and its reliance on foreign reserve sales to counter pressure on the currency.

“Monetary policy should restore its focus on price stability within a transparent and consistent operating framework,” it said in its report.

The IMF’s fundamental fear is that strong domestic demand and a weak currency (and hence higher import prices) will translate into higher inflation, hitting the competitiveness of the Turkish economy.

From the report:

Restoring the credibility of inflation targets requires that the policy rate be adjusted if headline inflation is projected to miss the year-ahead point target,” the IMF said citing its own inflation forecast of 8.5 per cent for year-end 2011, but tactfully omitting the central bank’s 5 per cent target, which the bank itself admits it will miss. “Our current inflation forecasts… indicate that some tightening would be needed to achieve the target for next year.

The central bank’s supporters claim that the eurozone crisis has vindicated its unorthodox approach to monetary policy – which involves cutting interest rates to diminish the flow of hot money while seeking to dampen demand with tougher reserve requirements for commercial banks.

The bank’s argument is that higher Turkish interest rates would magnify the downside risk the crisis represents and also increase the Turkish economy’s dependence on portfolio capital inflows.

But the lira has fallen by more than 20 per cent against the dollar and the euro since last November. While the central bank initially welcomed the fall as a means of reining in Turkey’s hefty current account deficit – above 9 per cent of GDP – it now worries the slide has gone too far.

This week, it has been particularly active on the currency markets in its bid to prop up the lira, selling $350m – the maximum it has allowed itself – in its daily auction on Wednesday. The next day the lira still hit an all time low of 1.85 TL to the dollar, amid the general market gloom, before recovering to 1.83TL on Friday.

The IMF isn’t impressed by the general approach.

“Halting foreign currency sales would conserve hard-earned reserves,” it said, noting that Turkey’s reserves are a distinctly finite resource. (They are reckoned to be about $90bn.)

It adds:

In the past few weeks the central bank’s reserves declined by some US$6 bn through sales, lower reserve requirements on foreign exchange liabilities, valuation changes, and foreign debt payments…. Absent global risk retrenchment, it is advisable to increase the policy rate to prevent an overly rapid depreciation.

Related reading:
Turkey: turning the corner?, beyondbrics
Turkey: rates on hold? beyondbrics
IMF: EMs still vulnerable to domestic pressures and external shocks, beyondbrics
EM currencies: the other shoe drops, beyondbrics

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