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Bloomberg

The Federal Reserve's halt to bond buying is testing central bankers' efforts to control inflation halfway round the world.

Two of the world's biggest emerging markets epitomize the struggle to weather spillovers from the U.S. With a determined focus on price stability, Reserve Bank of India Governor Raghuram Rajan is having more success than Turkish counterpart Erdem Basci, whose room for maneuver is hamstrung by a government demanding low borrowing costs.

Both countries saw their currencies plummet last year when investors pulled money out of emerging markets deemed most vulnerable to the eventual withdrawal of U.S. monetary stimulus. The outlook for the Indian currency has since then improved, with forecasters predicting the rupee will end March among the top 10 of 23 emerging-market currencies tracked by Bloomberg. The lira is seen among the bottom three.

"It's all down to central bank credibility and Mr. Rajan has brought tons of it," said Benoit Anne, London-based head of emerging-market strategy at Societe Generale SA, who recommends buying Indian 10-year sovereign debt against Turkish bonds. When Turkey "tells us their primary objective is to fight inflation, I don't think they convince anyone."

Inflation Rate

Turkey's inflation rate climbed to 8.86 percent in September -- almost double the 5 percent target -- from an average of 7.5 percent last year. By comparison, Rajan's inflation fight has begun to work, with the rate slowing to 6.46 percent in September after averaging more than 10 percent in 2013.

Basci, 48, is an 11-year veteran of Turkey's central bank and helped design a strategy that matches low interest rates with higher bank reserve requirements. Rajan, 51, is a former International Monetary Fund chief economist who warned in a 2005 paper to contemporaries in Jackson Hole, Wyoming, that deregulation and the use of more complex financial instruments had increased the risk of a global financial crisis.

In May 2013, when former Fed chief Ben Bernanke signaled its bond purchase program would end, both India and Turkey faced widening current-account deficits and plunging currencies that put them in the "Fragile Five" with South Africa, Indonesia and Brazil. Both nations opted to keep benchmark rates on hold in an attempt to protect growth that was slower than the 10-year average even as inflation was among the highest in their regions.

Rate Cuts

Rajan immediately changed course when he took charge in September 2013, saying the central bank's role is to maintain confidence in the currency by keeping inflation low and stable. He offered swaps for dollars raised by banks to shore up the exchange rate and boosted the key rate in three equal steps to 8 percent. Most significantly, he adopted a policy to slow consumer-price inflation to 6 percent by January 2016.

"If the developed world recovers, Turkey would be more vulnerable to outflows as the market does not believe they're in a position to hike rates and defend the currency," said Tatha Ghose, a London-based economist at Commerzbank AG. "Indian central bank policy has been more stable recently and so it can offer a better defense."

Basci, on the other hand, held the main interest rate at a record low of 4.5 percent for eight months after Bernanke's comments. In January, with the lira plunging, he raised the benchmark to 10 percent in an emergency meeting and simplified its multi-rate system that the the IMF had called "too complex."

Political Pressure

President Recep Tayyip Erdogan, a vocal critic of higher interest rates, soon began to pressure Basci, who in May lowered the rate by 50 basis points. Erdogan called that cut a "joke," and Basci reduced the rate another 125 basis points over June and July.

Turkish politicians have kept up the pressure on Basci since then. In September, Economy Minister Nihat Zeybekci said the rate should be cut based on a survey that showed inflation slowing next year, while last month Prime Minister Ahmet Davutoglu called on Basci to lower interest rates because of falling commodity prices, Hurriyet newspaper reported on Oct. 27.

Basci has sought to withstand the calls, with the central bank saying last month it would maintain its stance "until there is significant improvement in inflation."
Interest-rate swaps show investors expect India's benchmark rate will drop by at least 75 basis points, or 0.75 percentage point, by the end of 2015, according to data compiled by HSBC Holdings Plc. In Turkey, policy makers are projected to keep the rate unchanged, the data show.

Market Credibility

"The problem in the Turkish case is the current political pressure on the bank," said Ipek Ozkardeskaya, a strategist in Geneva at Swissquote Bank SA. India's "policies are understood by all, which gives them market credibility," she said. "Turkish policy is hard to understand and a source of volatility.


The political pressure probably won't dissipate before Turkey's general elections due June 2015, according to UBS AG. India now has one of its most stable governments in decades, with Prime Minister Narendra Modi in May winning the strongest mandate in 30 years as voters punished the previous government for policies that stoked inflation.

"The sense of a crisis was more acute in India, so Indian politicians have understood the need for change," said Manik Narain, a strategist at UBS in London. "In India the government is taking action to reduce the fiscal deficit while in Turkey the primary surplus is falling at a notable pace, making the central bank's life harder."
Giving Credit

Modi last month scrapped diesel subsidies as he looks to narrow the budget deficit to a seven-year low of 4.1 percent of GDP. His administration is selling stocks of wheat and rice in the open market to curb prices and is in talks with the RBI to adopt a formal inflation target implemented by a newly created monetary policy committee.
India is well prepared to weather any market volatility when the Fed begins raising rates as investors will identify regions with "macro stability," Rajan said Oct. 11 in Washington. RBI spokeswoman Alpana Killawala referred to Rajan's speeches on the topic when reached for comment Oct. 29.

Turkey's government also aims to shrink its fiscal shortfall to 1.1 percent in 2015 from 1.4 percent this year and has set up a committee to devise ways to contain food prices. Its primary budget balance excluding interest payments dropped by a third during the first three quarters from the same period a year ago, finance ministry data show, as slowing growth erodes revenues.

In October, the Turkish government lowered its economic expansion forecasts for 2014 to 3.3 percent from 4 percent and for 2015 to 4 percent from 5 percent.
The Turkish central bank declined to comment.

"The market is giving Modi credit for policy improvement whereas it's not prepared to do the same" for Erdogan, said Jim O'Neill, former Goldman Sachs Group Inc. economist and now a Bloomberg View columnist. "I much prefer India to Turkey."