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Stephane Couturier for Pictet

Turkish currency crisis

August 2018

Turkey's ugly choices

Turkey's government has backed itself into a position where it faces unenviable policy alternatives. Investors are watching closely.

As the currency crisis roils the Turkish economy, its government is faced with three options. It can raise interest rates sharply to defend the beleaguered lira. It can pull down the shutters and try to keep capital from fleeing the economy. Or it can print money.

Which of these alternative policy measures Turkish President Recep Tayyip Erdogan chooses will determine how well investors fare.

The best and most positive for markets would be for the Turkish central bank to raise interest rates sharply. At the heart of the currency crisis are the country’s deeply negative real interest rates. Two year local currency government bonds yield around 25 per cent, which is a best approximation of what the market thinks will happen to inflation– the year-on-year rate to July, latest reading available, showed a rate of 16 per cent, but a hefty devaluation in the lira since means it will climb sharply. Turkey’s dependence on commodity imports means that the fast falling lira is causing the country’s inflation rate to accelerate.  If the market’s right about the course of inflation, real rates will be deeply negative if official interest rates remain at 17.75 per cent.

In order to put a brake on this price spiral, rates would need to be hiked – and soon. As long as investors believe the central bank is committed to controlling inflation, this would stabilise the currency – albeit at the cost of what would almost certainly be a sharp recession. But with price pressures under control, the central bank would then be able to start cutting rates again, which historically has been a strong buy signal for emerging market investors. Typically, inflows of foreign capital nurture a virtuous circle of appreciating currency and falling inflation. 

Ouch

Turkish lira/dollar exchange rate

Turkish lira dollar exchange rate

Source: Thomson Reuters Datastream. Data from 30.12.2017 to 17.08.18

Unfortunately, Erdogan has been adamantly against raising interest rates. Indeed, he’s argued that interest rate hikes are what cause inflation. And his moves to end the Turkish central bank’s independence means that it won’t buck political pressure.

In the absence of a market-friendly solution, Erdogan can raise capital controls – restricting how much foreign currency can be taken out of the country. Controls can work for countries without a lot of foreign debt, like China. But for those like Turkey that have very high levels of external debt, which needs to be serviced and rolled over, capital controls cause serious economic damage.

There are already signs of soft barriers. Anecdotally, people who have tried to do large currency transfers abroad have been told by their banks that only limited amounts would be transferred.  Erdogan has already been calling for Turks to “show their resistance to the world” by converting their gold, euro and dollar holdings into lira.

Capital controls would lock up investors’ cash in Turkey, a distinctly unattractive outcome.

Erdogan’s final option would be to have the central bank print money to keep sufficient liquidity at domestic banks. The alternative would be crippling bank runs. But printing money under these circumstances would lead directly to further currency depreciation, further inflation and, ultimately, be highly damaging to the economy. Venezuela offers a clear example of how badly this policy can go.

Turkey’s economic fate hangs on which option Erdogan’s government chooses. Investors will be watching closely.