Currencies in free fall and the economies caught up in them

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

Currency crises occur when central banks cannot defend the official exchange rates, and recently taking centre stage as two countries in the region saw their currencies depreciate greatly. The two currencies in question are the Iranian rial and the Turkish lira.

So, what happened?

Countries support their national currencies by hoarding foreign currencies. As peculiar as this may sound, this is how demand for foreign currencies, in exchange for national currencies, is met by a country’s central bank.

Foreign currencies are acquired through revenues garnered through one or more of the following. One, commodity exports, such as cobalt by the Democratic Republic of Congo; two, trade facilitation, with Hong Kong being an example; three, borrowing from the debt markets, which many countries resort to when debt market conditions are favourable; four, attraction of foreign direct investments, which also ensures moral confidence besides a monetary one in a country’s currency; and five, return on investments abroad, such as Singapore’s sovereign wealth funds.

When countries gave gold up, somewhat, and the Bretton Woods system was established, the US dollar was assigned the guarantor role of monetary and global trade. In that vein, a central bank’s main task was transformed from building up gold reserves to those of dollars, ensuring their all-time availability to facilitate trade and pay for debt held in foreign currencies.

As the global economy expanded and trade diverged to different fiat currencies in addition to the dollar, central banks had to expand their arsenal and incorporate other currencies. Thus, they had to balance between their holdings and market needs.

That being said, central banks set official exchange rates based on: one, its own market sentiments; two, liquidity and the debt situation; three, global markets’ appetite for its own currency, as well as four, its ability to defend any official exchange rate that it quotes. Central banks manage the latter through their holdings of foreign currency reserves in addition to any anticipated foreign currencies’ income.

Basket of currencies

In setting rates, some countries choose to go for a hard peg with a single currency, most commonly the dollar, where every dollar for instance will get you the same amount of that country’s currency, etc. Such a peg could also be applicable to a basket of currencies with the same underlying logic, without necessarily disclosing the proportion of each foreign currency in the basket, partly done to safeguard against speculative behaviour by investors.

Other countries opt for a soft peg, where currencies are allowed to move upwards or downwards within a certain band. The country’s intervention, through its central bank and the latter’s reserves of foreign currencies, takes place whenever the exchange rate goes beyond what is set to be floor and ceiling for the exchange rate. When euros are needed, central banks expend those and the same applies for other currencies.

Going back to the Iranian rial and Turkish lira, it must be noted that each of the two countries amass foreign currencies differently, in line with what has been mentioned earlier on. Despite sanctions, Iran was able to build up its foreign currencies’ reserves through oil exports enabled by exemptions. However, sanctions prior to signing the nuclear agreement (JCPOA) ensured that neither inward foreign direct investments nor access to international debt markets were additional sources of foreign currencies for Iran, two sources that Turkey is heavily reliant on for its economy’s growth and survival.

Here’s a very short timeline of what happened. Iran signed the JCPOA in 2015 and was thus allowed billions of dollars that it chose not to invest in its domestic economy. Post signing of the JCPOA, many companies rushed into signing all sorts of deals to invest in the Iranian economy, which would have provided an additional source of foreign currencies besides those from oil exports.

However, and before most investments materialised, the US withdrew from the JCPOA in May 2018, re-imposed sanctions, and announced curbs on oil exports by November 2018. The US also made it clear that companies doing business with Iran will be subject to secondary sanctions, effectively making them choose between American and Iranian markets.

Access to dollars

Until March 2018, Iran had several official and unofficial exchange rates for its rial. There was an official rate the government supposedly supported, though could not provide dollars for. Other rates were decided by open market operations and by exchanges in the black market, which thrived as individuals lost access to dollars through official channels.

In April, Iran decided to unify its official exchange rate with the open market one at an unrealistic level that overvalues the rial, resulting in two things: one, multiple official rates depending on products and levels of access; and two, much more extended operations in the black market — the unofficial exchange rate. Between July 2017 and July 2018, the unofficial exchange rate dropped from around 30,000 rials for the dollar to around 118,000 rials for the dollar.

With its oil revenues limited and investors being warned away, there seems to be no light at the end of the tunnel for the Iranian economy, made worse by the impossibility of an IMF bailout for obvious reasons.

As for Turkey, I discussed in a two-month old article the intrinsic issues with the Turkish economy that initiated the lira’s downward spiral. Back then, the Turkish lira’s value was 4.5-4.7 to the dollar. In two months, the it lost more than 40 per cent of its value and is now hovering around 6.5 liras to the dollar.

As Turkey is over reliant on foreign direct investments as a source of foreign currencies, investors were spooked by the US sanctioning of two Turkish government officials and vowing to double tariffs on Turkey’s aluminium and steel. The loss of confidence in Turkey’s economy and the way it’s being managed dealt the Turkish lira its final blow, despite its relative stability in June-July 2018.

Illiquid reserves

Prior to the Turkish lira’s devaluation, Turkey has been building up its gold reserves in anticipation of sanctions being imposed on Iran, which was supposed to act as a barter exchange for oil and other imports from Iran. As investors sell their holdings in the Turkish economy and head for the exit, Turkey’s economy seems to be in an impasse, being stuck with illiquid reserves and neighbouring a sanctioned country.

Just like the case with Iran, an IMF bailout, which was a possibility a few months back, seems to be a far-fetched goal today. Right now, however, Turkey isn’t eager for one.

Summing it all up, both currencies seem to be on a downward spiral without a saviour that could bail out any of the two countries, never mind both. With restrictions being reintroduced on Iranian oil exports, and sanctions drying up investments, the Iran economy’s troubles seem far from over.

As for Turkey, its global and European markets integration could warrant it temporary relief from countries that are well-vested in its economy and hence need to safeguard their investments there. Given that market fundamentals do not support a strong lira, Turkey will eventually be left with either having to astronomically hike interest rates and risk its economic growth, which will only work temporarily if it even did.

Or accept a greatly devalued Turkish lira as the new reality. The last thought that I want to leave you with: what will happen to the Pakistani rupee if Pakistan doesn’t get an IMF bailout? Note: it is already down by more than 10 per cent in 2018.