ISTANBUL A corruption scandal shaking Turkey's government may delay for many more months a tightening of monetary policy that would stabilize inflation and stop the lira from plumbing record lows.
Across Turkish financial markets, there is a near-consensus that short-term interest rates need to be a lot higher - as much as 3 or 4 percentage points higher, some traders say - to be sure of relieving pressure on the sliding currency.
In recent weeks, this belief has strengthened as the global market environment has turned further against Turkey. The U.S. Federal Reserve's decision last month to start cutting its monetary stimulus has hit a number of leading emerging economies, and means more pressure on the Turkish lira, which sank 17 percent against the dollar in 2013.
But the economic and political pressures created by the corruption scandal, which erupted in mid-December and forced the resignations of three ministers, make it harder for Turkey's central bank to respond aggressively.
The damage which the graft investigations may inflict on business activity, particularly the construction sector, mean any interest rate increase could slow the economy yet further when it is already showing signs of losing steam.
The scandal has weakened the AK Party of Prime Minister Tayyip Erdogan just before local elections due in March and presidential polls in August. A rate rise, which would lift costs for Turkish home buyers and building firms, would be politically controversial.
"The central bank is more keen on supporting the economy rather than concentrating on inflation," said Mehmet Besimoglu, chief economist at Oyak Yatırım, a top Turkish securities firm.
"It seems to be comfortable with 7 to 8 percent inflation - only inflation risks heading to double digits would make it tighten policy aggressively."
Using unorthodox monetary policy, the central bank has guided short-term market rates higher in recent months. The average cost of funding for banks is at 7.17 percent, up from 4.52 percent in late May, but still below annual inflation which was 7.40 percent in December.
Foreign portfolio investors shoveled cash into Turkey and other emerging markets while they were booming and global interest rates were soft. However, the Fed's gradual withdrawal of help for the U.S. economy has raised the prospect of higher yields, encouraging investors to pull back from emerging markets including Turkey's.
Central bank data suggests fund outflows undermining the lira may continue for some time. Non-resident holdings of domestic government debt securities sank to $52.7 billion on December 27 from a $72 billion peak in May; equity holdings fell to $55 billion from $82 billion.
These drops only take the markets back to levels seen in August 2012, when the boom was already well underway. A return to the historically more normal levels seen at the start of 2012 would bring foreigners' holdings of debt and equities each below $40 billion.
To counter the effect on the lira, the central bank has supplied foreign currency to the market; it had spent about $15 billion by late December and central bank governor Erdem Basci said it would spend a further $6 billion by the end of January.
Market intervention in these volumes is proving enough to slow the lira's drop but not to halt it - and with net foreign exchange reserves of under $40 billion, the central bank cannot safely spend much more.
"The big picture is Turkey doesn't have enough reserves to spend on defending the currency," said Manik Narain, emerging markets currency strategist at UBS in London.
That leaves interest rates as the one way to stabilize the lira. But with Turkish rates still below inflation, they will remain a recipe for currency weakness unless they rise much more sharply - something other emerging economies have already learnt.
"The lesson from places such as Brazil and Indonesia is that you have to tighten very aggressively to have an impact when the market is going against you," Narain said.
This is why the timing of Turkey's corruption scandal, which involves inquiries into government procurement and prompted the ministers' resignations when their sons were among dozens of people detained, is economically unfortunate.
With the rise in companies' financing costs, analysts think economic growth could drop to as low as 2 percent this year, pushing up unemployment. The scandal may disrupt the government's ability to approve big building projects and extend contracts, which have been a motor of the economy.
Murat Yetkin, a columnist at leading newspaper Hurriyet, said the government had responded to the scandal by starting a "cleansing operation" against its political opponents in the bureaucracy, while prosecutors of certain affiliations were opening inquiries against civil servants with other affiliations.
"Expecting a civil servant to sign a document, any document, will be more risky and difficult than before," he wrote.
Besimoglu said the central bank would have to factor the construction sector into monetary policy. While an interest rate rise would help construction firms with foreign debt if it stabilized the lira, it could also curb their access - and that of their customers - to domestic funding. "Lending rates in that sector are critical," Besimoglu said.
Erdogan has to some extent politicized monetary policy. Last year he railed against a "high-interest-rate lobby" of speculators who he said were trying to engineer higher rates, and called for real borrowing costs of zero percent.
The central bank is technically independent of the government, but Basci was appointed with the approval of the AK Party. Few Turks believe he can ignore the political implications when deciding whether to tighten policy before this year's elections, which because of the scandal could be the toughest test for the AK Party in its 11 years of rule.
The upshot is that the central bank, which is due to hold its next monetary policy meeting on January 21, may delay any significant tightening of policy until after the March elections - and conceivably the August polls as well.
Emre Deliveli, a local economist and columnist who has worked at the central bank as well as international institutions such as the World Bank, said the central bank would probably wait until after the elections, unless a sudden, sharp drop of the lira forced it to take emergency action.
If the central bank moves, it is likely to tighten a little, perhaps by 1 to 1.5 percentage points at most, rather than the 2 to 3 percentage points which would be more certain to quell market jitters, he said.
Basci has shown no sign of blinking. He insisted on December 24 that the central bank would continue its policy of intervening in the foreign exchange market and adjusting lira money market liquidity with routine operations - though he did not totally rule out policy change. "The current policy stance is sufficient. We could take moderate steps if needed," he said.
Many investors would like the central bank not only to raise interest rates, but to abandon the unorthodox monetary framework adopted by Basci and return to more traditional policy-making.
It uses frequent market operations to manage banks' cost of funding in a band, the ceiling of which is its overnight lending rate, now at 7.75 percent; as the lira has weakened, the central bank has brought market rates up near the ceiling.
This approach helped authorities to cope with massive fund inflows into Turkey during the boom years, and was once seen as a possible model for other emerging markets. Now, many investors yearn for orthodox policy based on a single benchmark rate, which they feel would send a clearer signal that the central bank aimed to support the lira.
Besimoglu said the central bank might start removing parts of its monetary policy framework this year, as it became evident they were redundant in an era of tighter global markets. But there is no sign of a complete return to orthodoxy.
(editing by David Stamp)