This currency is a turkey

The top market story of the day has been the collapse in the Turkish lira which went from 5.60 against the dollar on Friday to around 7.00 at the time of writing – a collapse of 25% in one session. It is not as if the lira is coming off a period of overvaluation – quite the opposite in fact, since the currency has been sliding throughout much of the year. The root cause of the lira’s initial weakness was the failure of the central bank to tighten policy earlier this year. This resulted in the currency coming under pressure over the first four months of 2018, followed by a sharper depreciation following President Erdogan’s remark in May that “I will emerge with victory in the fight against this curse of interest rates … Because my belief is: interest rates are the mother and father of all evil.”

In short, Erdogan has peddled the view that rising interest rates result in higher inflation. To say the least, it is unconventional (though not necessarily wholly wrong if you have interest-rate linked products such as mortgages in the CPI basket, as the UK discovered 30 years ago, though that is not the case in Turkey today). As a result, Erdogan has browbeaten the central bank into holding off from monetary tightening. To make things worse, the political standoff between the US and Turkey has intensified in recent weeks, culminating in Friday’s response by Donald Trump to double the tariffs on imports of metals from Turkey. It is thus understandable that investors are feeling nervous and as a result Turkey has come into the market’s cross-hairs. But with the central bank’s credibility having been badly battered by its actions this year (or more precisely, by its inaction) it is difficult to see what it can do to stem the lira’s decline. It could jack up rates but once market confidence has been lost in the way that Turkey has experienced, this is nothing more than a futile gesture. Even a 100% annual interest rate amounts to just 0.19% on a daily basis. This is equivalent to trying to stop an elephant with a pea shooter. In other words, futile when the currency can decline by 25% in one day.

The other alternative is capital controls. One of the basic axioms of international economics is that economies cannot simultaneously run an independent monetary policy, a fixed exchange rate and free capital movement (the famous trilemma). On the assumption that Turkey wishes to regain some control over its currency, and on the basis that domestic monetary policy is likely to prove ineffective (as noted above), some restrictions on capital outflows appear to be necessary. Bear in mind that Turkey already runs a current account deficit, equivalent to around 5.5% of GDP last year. It thus has to borrow from the rest of the world to cover the fact that domestic investment is greater than domestic saving. Foreign investors are not going to be keen to lend to Turkey if they cannot get their money out. Theory would thus suggest that Turkey will have to deflate its economy in order to redress the savings-investment balance whilst the capital controls are in place.

This is exactly what the Asian Tigers did in the 1990s when currencies in the region came under speculative attack (though to be more precise, the policy was forced upon them by the IMF as a condition for financial assistance). Obviously, this does not bode especially well for Turkey’s near-term growth prospects, but people said very much the same regarding Thailand and Korea in the 1990s – and look at them now! There again, it did take five years for real GDP in Thailand to get back to pre-crisis levels.

The full effects of the Turkish lira collapse will continue to play out over the longer-term. Perhaps the Russian currency collapse of 2014-15 can offer some pointers. Ordinary citizens certainly did not escape unscathed, with consumers required to tighten their belts considerably. As in Russia, Turkish inflation is set to spike much higher. But whereas Russian inflation surged from 8% to 17%, Turkey is starting from an already-high rate of 16%. And the Russian central bank emerged with great credit as it managed the currency shock – the Turkish central bank’s stock is not exactly high.

One of the lessons we have learned from past currency crises is that what matters for the future is the nature of the policy response: Credibility can be regained if the authorities are prepared to make some hard choices. Moreover, despite the chatter suggesting that this could mark the start of an EM rout, we should not forget that Turkey’s problems are largely homemade. This is an object lesson of what happens when we try to run economic policy along populist lines, with Erdogan’s attempt to hold down interest rates to make life easier for his supporters about to backfire spectacularly. Populists of the world take note.