What the Lira's Plight Says About Turkey's Economy: QuickTake

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(Bloomberg) -- Turkey has been through a lot over the past few years: a coup attempt, a divisive referendum that concentrated more power in the hands of President Recep Tayyip Erdogan, and spillover from the Syrian civil war on its southern border. But all that doesn’t explain why the lira keeps coming under pressure during every major global selloff. Behind five consecutive years of depreciation is an unbalanced economy that must rely on foreign capital.

1. What’s been happening to Turkey’s lira?

It’s been one of the hardest-hit emerging-market currencies, shedding more than 10 percent of its value against the dollar and the euro in 2018. The only currency to fare worse among major peers is the Argentine peso, where the central bank was forced to raise interest rates to 40 percent and the International Monetary Fund was called in to provide emergency funding.

2. What’s spooking investors?

Investors complain that Turkey’s economy is overheating and its monetary policy remains too loose to contain runway inflation. Turkey’s also burdened by twin deficits. Its budget deficit has been exacerbated by a fiscal boost ahead of elections in June. Its current-account deficit -- a broader measure of a nation’s imbalance in trade -- has ballooned to more than 5 percent of output, among the largest in the G20 group of nations. That makes the lira particularly vulnerable to capital outflows. When times are good and investors are happy to take risk, money flows into Turkey, supporting the currency. When the mood sours and inflows slow, as they have recently, the lira buckles.

3. Why is Turkey’s current-account deficit so large?

Part of the problem is that Turkey lacks energy resources and is a major oil importer, which means the long rally in crude prices has inflated the bill. Turkey’s low savings rate means that breakneck growth -- the economy grew faster than China in 2017 -- has to be financed with money borrowed from abroad. Making matters worse, the bulk of the cash coming in is in the form of short-term portfolio flows into stocks and bonds, as opposed to more stable and desirable long-term investments in companies and factories. To make sure the money stays, Turkey’s central bank needs to make sure that interest rates are high enough to lure investors -- something it appears reluctant to do.

4. Why won’t the central bank raise rates?

To be fair, the central bank has managed to raise rates by more than 500 basis points since 2017, to the current level of 13.5 percent. The problem is that Erdogan, who has made himself Turkey’s most powerful leader since its founder, Mustafa Kemal Ataturk, supports lower rates. (He has his own ideas on what causes inflation). Investors worry that persistent political pressure from the government means the bank will resist taking further action until the market forces an increase. In the meantime, that ends up being counterproductive: the lira tumbles, inflation accelerates, and the size of the rate increase demanded by bond holders only rises. Some investors now say the central bank is so far behind the curve that it needs to raise rates by a massive 200 basis points, possibly at an unscheduled emergency meeting.

5. Would higher interest solve Turkey’s problems?

Not all of them, but higher rates could put the economy on a more sustainable path. The economy would cool, imports would slow and the current-account deficit would narrow. Turkey would need to borrow less, giving the lira and Turkey’s corporate sector, which sits on foreign currency-debt equivalent to 40 percent of gross domestic output, some relief. On the downside, higher rates would probably leave some borrowers unable to service their debts, so non-performing loans at banks would likely rise. To keep unemployment down in such a scenario -- it’s hovering at around 10 percent now -- Turkey would need to transition to a production- and export-led economic growth model. That’s easier said than done.

6. Is there a long-term solution?

Yes, structural reform of the economy. That means politically costly but long-overdue economic reforms to increase competitiveness, boost savings, and invest in education and technology that will help increase production of more valuable goods, boosting export revenue. Only then would the lira break free from its reliance on fickle flows of foreign capital.

The Reference Shelf

  • A rushed meeting of government leaders didn’t help the lira for long.
  • The lira’s weakness is helping spoil what could have been a record year for initial public offerings in Turkey.
  • QuickTake explainers on Turkey’s political, religious and geographical divides, Erdogan’s ideas about interest rates and central bank independence around the globe.
  • Turkey is about to have the most pivotal election in its modern history.
  • Back in 2015, Quartz reviewed the lira’s "long tale of woe" under Erdogan.

©2018 Bloomberg L.P.

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