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Turkey's Drastic Rate Hikes Could Be the Start of a Dangerous New Phase

31/01/2014 10:03 GMT | Updated 01/04/2014 10:59 BST

For those of us in the 'currency game', Tuesday night's decision by the Central Bank of the Republic of Turkey, to hike rates by 4.25% in one fell swoop, has set an eerie precedent. Monetary policy should be delivered in a calm, measured approach to the challenges an economy faces; tweaks and gradual adjustments to the engine of growth. The CBRT's move was one of panic. However, panic is a natural reaction to attack.

Turkey's economic issues have long been of concern to investors. Before the protests in Taksim Square provided us the media images to go with the political strife, tensions were already rising. The demonstrations merely made comparisons to the 'Arab Spring' possible for the broadcasters, which of course is exactly what that they wanted.

In recent months, growth has slowed to a relative crawl - GDP is expected at 4% this year following years of figures close to double digits - while the government is reliant on short-term funding requirements in order to finance its spending.

Unlike the profligate spending that governments in the West are accused of, which has in turn blown up deficits, the issue in emerging markets is that tax revenues simply do not constitute enough on their own to finance the necessary expansion needed to attract businesses.

Turkey wants investment from IT, biotech and aerospace companies - the new 'smart' economy - as much as India, Brazil, China, Nigeria, Hungary, Mexico and any number of other emerging economies. Roads need to be built, high-speed internet cables needs to be plumbed in, employees need to be housed; the shopping list is long and expensive.

The problem that emerging markets have is that this funding channel is a river that is all dried up. Investors now have to weigh up higher, more attractive rates from the developed world markets like the US and UK. Combine that with perennial fears of an emerging market slowdown led by China and the taps start to creak closed.

The fears of a funding gap's impact on growth and the future viability of the economic model has caused investors to charge for the exits, selling emerging market currencies in their droves. The central banks in turn have used reserves of foreign currency to try and prop up their currencies in an effort for stability. When this failed they resorted to interest rate hikes.

India's 50bps increase begat Turkey's 425bps which in turn begat South Africa's not entirely surprising 50bps yesterday afternoon. Despite these moves the market took little notice and took emerging market currencies lower on the day for two reasons.

The first applies to the Indian and South African situation in that the market believed that those 50bps increases are too small in the short term. South Africa's central bank was at pains to emphasise that its rate hike was due to a large increase in inflation predictions, moving through 2014, and not anything to do with the consistent aggressive falls in the ZAR.

That's probably a good thing given the 50bps increase and it bought the rand approximately 7 minutes of strength, before it fell to new 5 year lows versus the USD, GBP and EUR.

The second reason applies to Turkey and ii is a lot more terminal. Increases in rates of 425bps in one fell swoop are rare outside of crises - The UK government's response to Soros' attack on the pound in 1992 comes to mind - but investors will now worry about where the other shoe drops; has the CBRT fired its one and only shot and failed to land a fatal blow?

These situations get worse before they get better. The worst may yet be still to come for Turkey.

So where does the contagion spread to now? Given the moves in policy are of overall monetary tightening, the obvious options are those central banks who have expressed a desire to keep monetary policy loose. In the emerging market arena that would include places like Mexico and Hungary. We'll see whether this is that start of a dangerous new trend over the coming week.

Jeremy Cook is chief economist at World First