The sudden drop in the value of the Turkish lira may not have been so sudden if we follow the happenings in the Turkish economy and monetary policy in recent years. The currency plunged 7% to a new record low level in the second biggest daily sell-off after the 2021 crash, as the re-elected president and his government appeared to be switching to more mainstream monetary policy, including looser currency stabilising measures. This could mean abandoning existing capital controls and allowing the lira to depreciate freely until it finds a sustainable level.
Summary
- The Turkish lira has depreciated strongly in the past two years due to interest rates cuts and, more recently – the possibility of abandoning the capital control measures.
- The Central Bank of the Republic of Turkey (CBRT) has been selling its foreign exchange reserves to keep the lira from depreciating. As a result, the central bank's net reserves, including swaps, have turned negative for the first time in 21 years.
- When most other countries in the world started raising interest rates, Turkey was in the process of halving them from 19% to 8.5% leading to a spike in inflation primarily supported by the expansion of credit availability.
- Turkish lira might continue to fall in case capital controls are abandoned or eased and as long as a tighter monetary policy is not adopted by the CBRT.
“Unorthodox” monetary policy leading to record-weak Turkish lira
Before the presidential election in May, now re-elected Turkey's president, Mr Recep Tayyip Erdoğan told CNN that he has a thesis "that interest rates and inflation are directly correlated. The lower the interest rates, the lower the inflation will be." Such a thesis disagrees with the general economic theory now followed by most central banks around the world, implying that higher interest rates slow down economic activity and increase the value of the national currency leading to a decrease in inflation.
In line with his views on interest rates and inflation, Mr Erdoğan decided to cut interest rates in 2021. As a result, the Turkish lira lost ground, plunging a staggering 91.85% against the US dollar in the last two months of the year before stabilising at around 13.30 liras per US dollar in early 2022. Despite efforts by the Turkish authorities to prevent the currency from depreciating, it had reached 20 TRY per USD on May 29, 2023, just before plunging to 23.50 – a new record high level – in response to the possibility of abandoning the capital control measures.
Source: Tradingview.com
Central Bank's balance sheet crisis
Instead of tightening monetary policy, Turkey's officials have resorted to more unconventional measures to support the depreciating currency. This year alone, the authorities have sold around 24 billion USD from the central bank's reserves to support the lira and keep it from falling, resulting in a depletion of the central bank's reserves. According to the latest data reported by the Central Bank of the Republic of Turkey (CBRT), net reserves, including swaps, have turned negative for the first time in 21 years. Consequently, the country's economic administration, which heavily relied on reserves as its primary tool for stabilising exchange rates, has now exhausted its available options.
In the weeks leading up to and during the presidential elections, the government took several measures to curb the demand for foreign currency. It utilised reserves to prevent the rise of exchange rates. Based on central bank data, gross reserves decreased by 3.5 billion USD to 101.6 billion USD during May 15-19. Moreover, during the week of May 19, the central bank's net reserves fell to -0.2 billion USD. In the preceding week of May 12, net international reserves stood at 2.33 billion USD, indicating a net loss of approximately 2.5 billion USD in just one week.
A worrying level was also observed in net reserves excluding swaps, which amounted to -60.3 billion USD in the week of May 19, compared to -57.8 billion dollars in the previous week. Gold reserves have recently been sacrificed to prevent the escalation of exchange rates. In the week of May 19, gold reserves declined from 44.3 billion USD to 42.8 billion USD.
Depending on upcoming monetary decisions and the pace of selling the central bank's assets, Turkey could be reaching the limits of their usable reserves as soon as this summer. Surely, Mr Erdoğan may try to negotiate some financing deals with other countries. The Saudis and Qataris have provided Turkey with funding, as well as China and South Korea. Nevertheless, those would be swaps or other liabilities that may not be a sustainable long-term solution.
Inflation
Although nothing extraordinary these days on a global scale, inflation in Turkey might be noteworthy to be reviewed as one of the dominating factors in Turkey's predicament. Despite a slight reduction in the growth rate since November 2022 when it exceeded 80%, prices are still climbing annually at a pace ranging from 40 to 50%. It is uncertain whether this slowdown will continue, and inflation expectations are not firmly anchored. Moreover, some informal sources suggest that the official figures may have been artificially suppressed in the run-up to the elections and underestimate the actual inflation rate, which may be closer to 100% rather than 40%.
Source: Tradingeconomics.com
What was the reason for inflation to skyrocket in Turkey at the end of 2021? First of all, it has historically been considerably higher than the generally accepted 2% target among most Western countries. However, even for Turkey, 80% inflation is unusual. Second, and potentially the reason also for the first factor, is that Mr Erdoğan is a strong advocate for low interest rates (read – expansionary policy), which has resulted in high levels of private credit. Meanwhile, the fiscal policy has remained tight. Since Mr Erdoğan became Turkey's president in 2014, the government's budget deficit has hovered around 1% of the country's GDP, except during the Covid-19 pandemic when the deficit rose slightly to 3.5%.
Source: Tradingeconomics.com
Part of the reason for such high inflation in Turkey may be found in the same factors as in many other countries, such as supply chain disruptions during the Covid-19 pandemic, rising global energy prices and strong US dollars.
Meanwhile, a rather dramatic expansion of credit availability began during the Covid-19 pandemic, while fiscal policy, such as direct fiscal support, remained relatively tight. Maintaining a tight fiscal stance in the face of inflation may be challenging, especially as Mr Erdoğan's government has used tax relief measures to mitigate the impact of inflation on the public. Additionally, the government's fiscal condition may be further strained due to a significant portion of its relatively modest public debt being denominated in foreign currency. Consequently, as the currency depreciates, the burden of lira-denominated debt increases, placing additional pressure on the country's fiscal situation.
By the time most countries started their monetary tightening cycle by raising interest rates, Mr Erdoğan was already halfway through decreasing Turkey's key interest rates from 19% in September 2021 to 8.5% in April 2023. As a result, Turkey's inflation-adjusted rates approached a staggering -80%, serving as a powerful incentive to borrow. The explosion in loans resulted in growing real estate prices, an additional boost in inflation, higher imports and eventually – more pressure on the Turkish lira.
On a side note, it may be worth mentioning that higher imports have resulted in a historically high trade deficit widening by 19% on a year-on-year basis and reaching 12.7 billion USD in May 2023. A trade deficit is known to have the potential to weaken the domestic currency, similar to inflation.
Conclusion
Even if the re-elected president agrees to pursue a more conventional monetary policy, history tells us that he could just as easily change his mind. This may keep investors cautious amid some signs of relief, such as five-year credit default swap spreads, which represent the cost of protection against default, normalising at lower levels and Turkish dollar-denominated bonds rallying.
Abandoning capital controls may devalue the Turkish lira further to a sustainable level. Goldman Sachs analysts have predicted that the lira may continue to fall to 28 per USD in the next year. Another effect of abandoning capital controls could be the recovery of the central bank's balance sheet to a more sustainable level. Meanwhile, a notable fall in the country's inflation rate may not be prospective until a tightening monetary policy is not introduced, including higher interest rates.
Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis, and opinions contained, referenced, or provided herein are intended solely for informational and educational purposes. The personal opinion of the author does not represent and should not be constructed as a statement, or investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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