The author is President of Queens’ College, Cambridge and an advisor to Allianz and Gramercy
After attempting to defy internal and external economic logic by repeatedly cutting interest rates, Turkey embarked on new unorthodox measures this week to stabilize its currency.
Whether the authorities will ultimately be more successful this time around boils down to a simple question: will Turkish households and businesses see this “breaker” as a bridge to a broader package of measures addressing the underlying drivers of economic and financial instability or, instead, as a travel destination? that soon turns out to be inherently unstable?
It is difficult to put into words how disorganized the Turkish currency markets were on Monday afternoon. The lira had weakened to over TL 18 per US dollar, halving its value in just two months.
The rate of devaluation gained momentum, as did the chaotic nature of trade, despite the central bank intervening, further depleting its international reserves.
It was only a matter of time before all of this led to a further rise, with inflation already exceeding 20 percent. A growing segment of the population chose to protect their savings by exchanging lira deposits for dollars and other hard currencies (what economists refer to as “dollarization”).
The immediate cause of all of this was the 5 percentage point drop in domestic policy rates since September, when both internal and external conditions called for a hike. Inflation rose, the currency was under pressure and the global monetary policy environment began to tighten, particularly in emerging markets.
Desperate for a circuit breaker, the authorities this week decided on a series of complex measures that can best be described as an interest rate equalization mechanism with guarantees to preserve the real value of lira deposits, measured in hard currency.
Aside from lowering the incentive for further dollarization, this approach appears to have three side benefits for the Turkish authorities. First, it avoids the effects of a partial and implicit rate hike on the rest of the economy. Second, since the guarantee applies to deposits with a maturity of 3 to 12 months, it encourages the extension of the average maturity of such deposits. Third, it helps ease the strong and rising inflationary pressures.
All of this at a time when, prior to the announcement, the currency was trading in “surplus” after most economic measures.
These benefits come with significant risks. The mechanism puts a heavy funding burden on the financial accounts / central bank unless other measures are taken to control inflation and limit renewed pressure on the currency away from dollarization. If the mechanism fails, it will further undermine the credibility of policymakers and make it more difficult for the next package of measures to take effect quickly, even if it is comprehensive and appropriate.
It is the still large group of depositors of the Turkish lira that will determine the outcome within weeks. If they trust the policy response and are little concerned about possible collateral damage, they will encourage others to buy the domestic and foreign currency. The government can support this process by credibly signaling that the latest measures are not an end in themselves, but a bridge to a broader policy package.
This includes explicit rate hikes by the central bank, which are still necessary at this point in time, but no longer sufficient. Turkey will also have to look for other internal anchors, such as fiscal tightening, and perhaps external ones, such as an agreement on an IMF program that provides both funding and external validation.
All of this must be done while avoiding the understandable temptation of capital controls which would undermine a historically powerful and still effective open growth model that exploits Turkey’s many “competitive advantages”, both economically and financially.
Turkey has bought artificial stability through a new package of unorthodox measures. It is unlikely that this will lead to real stability unless Turkish citizens are convinced that their currency crisis is really over.
This will only happen if the government quickly moves to a broader – and yes, more orthodox – political approach. Otherwise, the country’s strong economic characteristics would be further undermined. Because the laws of economy and finance are always set limits.