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With economic growth and job creation still slow to materialize in the Western world, interest rates remain at record low levels in many of the world’s key developed market regions. But in resource rich developed markets and commodity intensive emerging nations, inflation rates have begun to climb sharply higher in recent months. This has forced many central banks in these rapidly developing countries to boost their benchmark rates in order to fight off rising prices. Unfortunately, this has had unintended consequences for the world’s industrializing countries as it has pushed a tsunami of hot money into these emerging nations, boosting asset prices across the board.

This is largely due to the fact that many investors have abandoned low yielding markets at home for the often higher yielding emerging nations thanks to an ever increasing interest rate gap that has made this move even more enticing than usual. In response to this giant wave of hot money, some markets have sought to go in the opposite direction, cutting rates and closing the interest rate differential gap, potentially helping to stem the tide of asset inflows. One nation in particular that has been implementing this strategy is Turkey. The country’s central bank slashed rates by 50 basis points in December, and surprisingly enough, cut rates again in January by 25 basis points down to an all-time low of 6.25%. “It seems somewhat perverse that we have rate hikes in Poland and Hungary, the European Central Bank warning of rate hikes and concern that the U.K. may soon need to hike policy rates ... and the one country in Europe with stellar growth ... is easing policy rates still,” said Tim Ash, economist at the Royal Bank of Scotland.

While the move is certainly unorthodox, it could work for Turkey given that inflation levels are still moderate in the country and that other issues are more pressing for the nation. For example, the move also looks to help the nation rein in its current accounts deficit, since a lower rate looks like to push the Turkish lira down, making exports cheaper and thus more in demand by foreign nations. This is becoming an especially severe problem in the case of Turkey where the current account deficit is approaching $40 billion a year, a figure only exceeded by seven other nations for which data was available. The lira has already lost about 10% against the dollar in the last three months so hopefully the continued weakness in the nation’s currency can allow Turkey to close the current account deficit without stoking the fires of inflation too much.

Turkey ETF In Focus

Currently, 17 ETFs offer exposure to the Turkish equity market although just one has more than 20% of its assets allocated to the country: the iShares MSCI Turkey Investable Market Index Fund (NYSEARCA:TUR). Unfortunately for investors in the fund, TUR is heavily exposed to financial companies which are among the most impacted by the recent news. Financials make up slightly more than half of the assets in the fund. In fact, all three of the fund’s top three holdings are financial firms, accounting for nearly 31% of the total assets in this popular iShares ETF.

The news looks to hit the Turkish banking sector especially hard since it comes after the central bank announced an increase in reserve requirements for banking deposits in December and further restrictive comments by the bank at its January meeting. In a statement according to The WSJ, the bank’s monetary policy committee signaled that “additional measures” would be taken to limit credit expansion, stressing that “the net effect of the measures which have been taken or are envisaged under the new policy is tightening.” This suggests that while rates were lowered, it will likely have a negative impact on financial service firms which still see overnight rates of 1.5% for borrowing and 9% for lending, potentially giving banks greater incentive to keep cash on their books in order to benefit from this growing disparity between the overnight rates and the benchmark interest level.

Thanks to this sharp decline, TUR is falling in the footsteps of its fellow emerging market funds that have seen a rough start to 2011. TUR has declined by almost 5% so far this year and has declined by 17% over the past quarter, suggesting that the continued attempts to stop the flow of hot money into the Turkish market may not be the best environment for stocks, at least in the near-term.

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Disclosure: No positions at time of writing.

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Source: Surprise Rate Cut Sinks iShares Turkey ETF