Semih Idiz | Aug 15, 2018 | 0
Turkish Lira: The “Yanny or Laurel” of Economic Theory
Imagine if the recent “Yanny or Laurel” internet phenomenon went like this: Every single one us heard “Yanny”, with only one person claiming to hear “Laurel” and he is the one person with the power to shut down the internet if we didn’t all agree. That’s the plight of Turkish Lira in a nutshell.
Very rarely, there are times in financial forecasts when all the gears inside the economic mechanisms are so in place that, the picture is crystal clear, and the outlook, as well as the current situation, seems to make complete sense. It should be no surprise for anyone with a basic understanding of the rules of economics to see that the Turkish Lira is precisely where it needs to be: down at the gutter.
The Turkish currency has been continuing to sink in a downward spiral for all of 2018. And it is down by 19% against the dollar since the beginning of the year. This follows the 7.4% loss it had already suffered in 2017. On a broader sense, the currency has been on a decline for the last decade, but the steepening of its fall in recent months owes to recent negative economic developments that have caused a mass fleeing of foreign capital from the country, and thus, an progressively shrinking arsenal of weapons with which the government can fight against.
The pundits of the Turkish economy, and President Erdogan in particular, have been boasting about the admittedly impressive 7.4% GDP growth Turkey has managed to book in 2017. But what must be noted here is that this growth was mostly fueled by strong domestic demand, and the contribution by net foreign demand was rather limited. However, with the inflation having now comfortably settled on a double-digit number (12.4% to be precise -more than double the state’s target of 5%) the purchasing power of the nation is waning and is likely to continue falling for the foreseeable future.
What is, of course, more troubling is the heights the current account deficit has climbed. We are standing at a risky 5.5% (of GDP), which makes Turkey dangerously susceptible to worldwide economic trends.
Turkey had held its ground against the economic meltdown of 2008 thanks to its strong domestic demand for housing and construction sector buoyed by a low interest rate policy. This is not where we stand now. Housing demand has all but evaporated, mega construction sites in Istanbul and other metropolitan areas are awaiting courters, or else, lie mid-assembly, unattended. Walk along the streets of residential areas in Istanbul, and you will see a dozen for-sale signs on virtually each and every one of them.
Another worldwide economic turn is sure to hit Turkey much more seriously this time around, since a high CAD makes a country more dependent on capital inflows to finance its debt. If foreign investors shy away from lending money -or worse, begin liquidating their investments, Turkey will need to create surpluses in its budget to finance and pay back the debts it already has. That is a recipe for disaster in Turkey’s current state, as it will force a plunge in consumption, investments and government expenditures. And since most of Turkey’s debt is in foreign currencies, a weaker Lira would add fuel to the fire.
Respected economist and financial strategist Russel Napier recently summarized his concerns for Turkish economy in an interview he gave to the Swiss daily Neue Zürcher with a stern warning: The collapse of the Turkish economy has begun. He particularly points to Turkey’s foreign debt of $B400 and warns that the country may not fulfill its foreign obligations following the election. He thinks European banks that have huge outstanding loans to Turkey will be the ones that will be hit the hardest, and that the EU will have to step up to bail them out. He points to the recent pleas by large Turkish conglomerates such as Dogus Group and Yildiz Group to have their debts restructured as the immediate omen for worse times to come.
In the light of all those troubling signs, Turkey -or rather President Erdogan himself, is hellbent on not letting the interest rates rise, which would be the most economically sound thing to do in these situations. Raising interest rates curb inflation and cool down the economy while making it more motivating for foreign investors to keep their funds in Turkey even if they don’t boost them. If less foreign funds leave the country, the current account stays more stable and the pressure on Turkish lira eases -at least a little bit. However, it is inconceivable that President Erdogan still has to be convinced of these basic economic facts. Mr. Erdogan recently stated during his visit to the UK that high interest rates are the reason for inflation -not the antidote to it. And to think that he told this to a group of international hedge fund managers while asking to hold more power in economic policies? Unbelievable!
The graph below shows the inflation rate charted against the interest rates in Turkey for the last five years. The increasing disparity between the two not only instigates an exodus of foreign capital in search of a better investment opportunity, it also chases down the domestic savings rate in this country, which has traditionally been low anyway. Why would you even consider saving money in Turkish Liras in a Turkish bank when the inflation is 1.5 times above the prevailing interest rate, with the dollar gnawing away at your hard-earned cash daily?
Whatever Mr. Erdogan thinks about what governs the laws of economics, he must agree that there is no better time to put his adversaries’ theories into practice than right now and let the Central Bank operate freely (and hopefully raise the interest). Higher interest rates surely will not solve all of Turkey’s problems. But from where we stand, even a slight ease of pressure on the CAD can help the Lira’s demise. Sure, it will dampen the GDP growth and curb investments, but the effect on the country’s exports should be negligible: after all, Turkey’s exports increased only marginally from $B14 to $B15.5 monthly during the period when Turkish Lira declined sharply.
But will the Central Bank be able to act? Not according to the markets. Turkey’s CB has been speaking about monitoring the unhealthy moves closely for a while now, but they have not interfered much, so far. They did intervene in the market through selling the dollar outright when the USD hit 4.50 area for the first time, but hedge funds quickly recuperated and drove the parity above 4.58 as of Monday the 21st. In the end, no one can stand against the tide of the market forces for long, not even central banks. There are many recent instances where countries tried to suppress the market through intervention, but their cure proved to be nothing more than a placebo that had to be replaced by the bitter pill of diminished foreign currency reserves with nothing to show for it.
The next scheduled meeting for Turkish Central Bank is on June 7th -provided an emergency meeting does not take place beforehand. If they come out of the meeting with anything less than a 100bps hike, it will merely be a symbolic move of running with the hare and hunting with the hounds. Half measures, at this point, will actually fare worse than no measures at all as it will seriously damage the CB’s credibility to implement a stout monetary policy.
We must, however, look beyond the immediate scope of monetary policy if we are serious about tackling Turkey’s economic woes in the longer term. Higher interest rates may be a start, but they are nothing more than a means to an end. The end game is the need for reforms, particularly in the labor area: pensions, severance pays, wage indexation, etc. From the looks of it, the looming elections do not offer anything close to being a remedy either. To the contrary we have politicians getting increasingly more and more populist: Meral Aksener of IYI Party promising to wipe off citizen’s debts, and Muharrem Ince of CHP pledging a house and a job for each family, and unrealistic economic subsidy for farmers. And we all know, from history, what they will say should they clutch the presidency: “We inherited a wreck.”
A wreck, indeed.