News in Charts: Currency crisis in Turkey, preventable or intentional?

The dollar value of the Turkish lira fell as much as 50% in the last three months, before partially recovering. As FX volatility escalates, policymakers have shown little appetite to step in to stabilise the currency. In fact, measures by the central bank, under pressure from President Erdoğan, have actively fuelled the currency’s sharp devaluation rather than stem it. Investors are becoming increasingly bearish towards the lira, as confidence in the credibility and independence of the central bank wanes and relations with the West remain strained.

Measures announced this week to compensate local currency deposits against currency fluctuations seem to have gone down well with markets. After the announcement on Monday the lira strengthened 25% against the dollar. However, these measures fail to address the underlying drivers of inflation and the currency weakness which the country has been experiencing for years. As a consequence, propping up savings is likely to add significant pressure to the government’s budget going forward. It is also questionable how much effect such a measure will have on an economy in which the majority of savings is not held in local currency as a result of systematic devaluation.

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Inflation has been on the rise in Turkey since October 2019. This was unsurprising given the four months prior to this had seen the central bank shave ten percentage points off its policy rate. With the lira now more than three times cheaper relative to the dollar than it was five years ago, upwards inflationary pressure on the net importing economy shows no signs of easing.

Conventional monetary policy frameworks such as the Taylor rule suggest that the appropriate response to higher inflation is to raise the policy rate by more than the increase in inflation (in other words, to raise the real policy rate). However, President Erdoğan is a staunch believer in the idea that higher rates stymie investment and exports. He is also a strong believer in Islamic values and was recently quoted saying: “We’re lowering interest rates. Don’t expect anything else from me. As a Muslim, whatever (Islamic teaching) requires I will continue to do that”. It seems likely, therefore, that rate cuts will continue. The impact on inflation appears to be an afterthought, if that.

Failure to follow a conventional policy framework is not the only reason the central bank’s credibility is being tested. Of the six monetary policy committee members, four were appointed this year, while one was appointed in 2020. Şahap Kavcıoğlu, the fifth chief of the central bank during Erdoğan’s time in power, has shown his support for the president’s view. During his short time in the position rates have fallen five percentage points, from 19% to 14%, despite rising inflation.

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Policy rate cuts are not the only central bank instrument that is fuelling the lira’s devaluation. Foreign exchange reserves, usually deployed by a central bank to support its currency in times of devaluation, have more than doubled since September. In 2020, investors had been worried that dangerously low central bank reserves would be insufficient to stabilise the lira. In recent months however, the central bank has turned this strategy on its head, using lira to buy up foreign currency. This has the effect of increasing the supply of the Turkish currency and hence amplifying its devaluation relative to other currencies.

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President Erdoğan ’s aim is for a devalued lira to boost the country’s exports as they become cheaper abroad. He has also argued that low interest rates encourage consumption and investment. While both of these arguments are in line with economic orthodoxy in the short term, unless inflation starts out a long way below its target (which is not the case in Turkey), these policies would normally be judged as coming at a heavy cost to the economy in the long run. Low- and middle-income groups are already suffering as high inflation erodes their real incomes, while businesses, which often rely on imported inputs, are seeing rising production costs. Aiming to make exporters richer at the expense of households and importers is unlikely to appeal to the masses. Policymakers have recently tried to offset this by raising the minimum wage by 50%. In essence, wages equal productivity growth plus inflation, i.e. real wage growth is just labour productivity growth in the long run. If wages rise faster than productivity growth plus whatever the target inflation rate might be, it is likely that inflation will subsequently exceed its target. That is the first step in creating a wage-price spiral, which might already be underway in Turkey.

An improving current account and trade balance suggests Erdoğan is achieving his aims for now. However, the country’s current monetary policies are unsustainable. If the central bank continues to cut the policy rate, inflation will probably continue to accelerate. The orthodoxy would argue that you can buy more growth with more inflation for a short period, but in the long term all you are left with is more inflation. Time will tell if the orthodoxy is correct.

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