Turkey Can’t Take Much More of Its Currency Crisis

(Bloomberg Opinion) -- A currency crisis is bad enough for Turkey. A full-blown economic crisis would be much worse. The country moved a little closer to one on Friday, but it can still avoid the worst-case scenario if it acts quickly to contain the spreading financial instability and maintain its considerable economic potential. The rest of the emerging world has a stake in this, too.

Friday was a particularly difficult day for the Turkish financial system. Further currency volatility, including a trading range of 10% for the lira, was accompanied by an additional daily depreciation of more than 4%. The stock market lost 8% in a hectic session that triggered two circuit breakers.

The widening financial instability fueled concerns about adverse spillovers to other parts of the economy, from a further boost to inflation, which is already above 20% and eroding households’ purchasing power and savings, to industrialists sounding the alarm about damage to production and investments.

The immediate cause of the financial volatility was yet another economics-defying interest rate cut by the central bank on Thursday. The 100 basis point reduction in the policy rate, to 14%, brought the cumulative decline to 500 basis points since September. It came when other central banks, especially in the emerging world, are raising interest rates or, in the case of the Federal Reserve, reducing monetary stimulus by tapering asset purchases.

Until last week, it seemed as if only the lira was taking the brunt of this unorthodox monetary policy, losing half its value this year despite central bank foreign-exchange interventions. Measured in local currency, the stock market had done relatively well, especially because many viewed it as the best inflation hedge domestically. On Friday, however, that “hedge” fell victim to a growing realization of the risk of mounting and severe damage to an economy with otherwise strong attributes.

The longer the disorderly moves in the currency persist — and they have already become quite protracted — the greater the risk of both internal and external amplifiers.

Internally, households and companies are being pushed to speed up their use of the dollar or other “hard” currencies as they scramble to counter the fast-deteriorating value of their balance sheets. The impact on the economy is easily accentuated by capital outflows as foreigners withdraw funds. Meanwhile, the confidence in the central bank’s ability to stabilize the currency diminishes with each failed intervention that also erodes the country’s international reserve.

By virtually any measure, the lira has already overreacted, or overshot, significantly to the central bank’s policy,  especially given the country’s economic attributes, which now include a widening current account surplus. But this does not mean it cannot overshoot even more. Indeed, the history of currency crises in emerging markets is littered with examples of countries unable to contain and reverse a currency overshoot before even more damage is done.

The longer the currency disorder persists in Turkey, the more a reversal in the central bank’s interest rate policy goes from being both necessary and sufficient to just necessary. Turkey may already be at the point where it needs not just a more comprehensive set of domestic policy adjustments but also some sort of supplementary external anchor. And while capital controls will surely be considered, their attractiveness is dimmed by the potential structural and reputational damage to a country that has flourished on being open to global trade and investment. They would also temper the enthusiasm of investors otherwise interested to be part of a financial recovery from such depressed levels.

Until now, many of Turkey’s considerable economic strengths have mostly avoided damage from the currency instability, thereby maintaining the potential for a speedy recovery and economic prosperity. The longer the authorities wait to decisively stabilize the currency, the greater the threat to the economy and the higher the risk that what has been for now a strictly domestic affair also blows winds of instability to other emerging markets.

More From Other Writers at Bloomberg Opinion:

• Erdogan’s Dangerous Obsession With Low Rates: Bobby Ghosh
• Turkey Wants the Impossible: Low Rates, Stable Lira: Daniel Moss
• Erdogan Leads Turkey Deeper Into Crisis: Bobby Ghosh

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include "The Only Game in Town" and "When Markets Collide."

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