Turkey’s plunge into a currency abyss yet again

This article appeared originally in Gulf News: link to original article

The Turkish lira lost one-fifth of its value since last year and two-thirds since 2016. And despite the recent attempt by Turkey’s central bank to raise one of its key lending rates, the situation is far from being resolved and stabilized.

So, will Turkey’s lira continue its slide downwards? Will Turkey resort, sometime in the future, to the extreme measure of dropping zeros from its currency like it did in 2005? Or will it seek a loan from the International Monetary Fund (IMF), as it did in the past, while it struggles with attracting less foreign direct investment (FDI) into its economy?

This article will explore the historic context behind the Turkish lira’s woos since the formation of modern Turkey, investigating key economic factors and attempting to answer the above questions.

Inflation, a key word that connects the answers to all of the above questions, is almost enshrined in Turkey’s modern history. Beginning in the 1970s and until the mid 2000s, Turkey’s average inflation rate exceeded 35 per cent. At two junctures in its economic history, in 1980 and in 1994, Turkey’s inflation rate skyrocketed to above 100 per cent, attributed to economic factors that seem to be at play today.

Those include fiscal expansion, public sector deficits, drop in short-term capital inflows, and currency devaluation. Turkey floated its old lira in 2001, and in 2003, the IMF came to Turkey’s rescue with a $16 billion loan package. Two years later, Turkey dropped six zeros from its old lira and introduced a new Turkish lira.

Now, given this historic context, does it mean that it’s quite ordinary for Turkey’s economy to go through similar inflationary, or hyperinflationary, cycles every 15-20 years? And whether or not that’s the case, what drives those cycles?

I am inclined to believe that this is the first downward cycle for the new Turkish lira, which was introduced in 2005. If you look at data from the time of its introduction and until today, the new Turkish lira continued to lose value unabated. As a matter of fact, the lira today is worth half its 2005 value, measured against the dollar.

The downturn in the new lira’s fortunes seems to be connected to the same fundamental economic factors that were behind the old lira’s downfall. With the exception of public sector deficits, fiscal expansion, drop in capital inflows (including FDIs), and currency devaluation are in play today.

For illustration purposes, interest rates must be high enough to attract capital inflows, or FDI, but not too high to stem liquidity in the country’s economy. Higher FDI, in dollars and other currencies, encourages a country’s central bank to print and circulate more of its currency as its foreign currency reserves gets bloated. Such a balancing act would supposedly mitigate lower liquidity rates from higher interest rates, without provoking too much inflation. A higher inflation rate makes a country’s currency worth less, resulting in its depreciation if rates are not hiked further.

This way, we are back where we started. I do not envy a central banker trying to balance all of the above without jeopardizing a country’s currency, and with it the livelihood of its citizens.

Back to Turkey and its lira. What’s quite clear from data extended over the mid-2000s until today is that money supply in Turkey’s economy has been on an upward trajectory, even though there weren’t foreign direct investments to back up that money supply. To elaborate, the increase in money supply is the result of printing money, while political pressure was exerted on its central bank to not increase its interest rates.

The central bank was however allowed to raise a key lending rate from 13.5 per cent to 16.5, after the lira lost 5 per cent of its value in a single day. Compared to about 40 per cent average interest rates in mid-1990s and mid-2000s, 16.5 per cent looks like a walk in the park for Turkey’s economy.

The above explained economic factors are all aggravating and fueling an inflation rate that could eventually spur out of control. And with the US Federal Reserve hiking its interest rates, Turkey’s central bank will be left with three options: 1. Further hike its interest rate; 2. Reduce money supply and dry up liquidity through various means; and 3. Encourage foreign direct investments, or capital inflows from Turks living abroad.

The latter seems to be the prevailing argument for now. Whether that will work or not is subject to confidence in Turkey’s economy, which doesn’t seem to be flying high nowadays. Quoting data from the Washington-based International Institute of Finance (IIF), Reuters reported that “[f]oreign investors withdrew $1.15 billion from Turkish government bonds and stocks in the first three weeks of May”. This is not it though.

In its 2017 “World Investment Report”, the United Nations Conference on Trade and Development (UNCTAD) documents a declining pattern in foreign trade investments attracted by Turkey between 2010-16, falling by 31 per cent in 2016 alone. Also, according to Emerging Markets Private Equity Association, southeast Asia and sub-Saharan Africa are the top regions for funds raised, while “Turkey-focused funds raised just $25 million in 2017, a significant decline from last year’s $824 million total”.

Moreover, and though ranked as the second most attractive emerging market for investments by a Bloomberg analysis, which is mainly due to its lira’s depreciation, Turkey is not among the top recipients of foreign direct investments for 2018, according to UNCTAD. Additionally, in “A Global Foreign Investment Attractiveness Index”, which looks at macroeconomic stability, financial structure, and market potential among other factors, Turkey ranks 47 out of 109 countries ranked in terms of FDI attractiveness.

Going back to the questions raised earlier, the depreciation of the lira is an ongoing trend since the introduction of the new Turkish lira in 2005. Given that all factors in play seem to be serving a further devaluation of the Turkish lira, it is unlikely for the lira to change course and appreciate anytime soon.

And though this creates a decent opportunity for Turkey to increase its overall exports and reduce the increasing trade deficit, it also makes it more expensive for Turkey to service its government and corporate debt denominated in foreign currencies. Different estimates put such debt at more than 50 per cent, predominantly in dollars and euros.

Now, is inflation in Turkey going to get out of control like it did in the decades preceding this millennium, resulting in a lira with multiple zeros on it? Very unlikely. However, there seems to be a very non-economic belief in Turkey’s government that a higher interest rate is the root cause of a higher inflation rate. If such a belief wins the day, especially post the upcoming presidential and parliamentary elections on June 24, Turkey’s economy could be headed towards an economic abyss of high inflation and a severely devalued lira.

If such a scenario does take place, and if the loss in confidence in Turkey’s economic fundamentals further limits FDIs, then an IMF bailout may be as realistic as in the early 2000s.

With an upward trending fiscal expansion and a downward trending lira’s value, Turkey’s economic issues are far from subsiding, and the new lira might meet the fate of the old one. The last thought that I want to leave you with: if the IMF was a no show, can Turkey be bailed out by a single country when push comes to shove?