Ankara made a significant step towards restoring market confidence on Thursday, hiking interest rates by 24%. The hike in itself is substantial, but the institutional significance of the move is far more meaningful.
The distinguishing features of the Turkish crisis
Turkey is not alone among emerging economies to suffer a currency crisis. However, there are two distinctively Turkish features in its unfolding crisis: one positive and one negative.
The first is that Turkey’s economy is less dependent on commodities and should, theoretically, be more resilient to the emerging global trade war. Unlike Argentina, Brazil, and South Africa Turkey is not a major commodity exporter dependent on the international price of soybeans, beef, or gold.
The second is that markets do not trust the independence of the Turkish Central Bank. The resignation of the Deputy Governor and Monetary Policy Board member Erkan Kilimci in August underscored the political friction between the government of President Recep Tayyip Erdogan and Turkey’s banking institutions.
Although the Turkish crisis is primarily linked to foreign denominated debt, analysts have said that the willingness of the Turkish government to intervene in monetary policy is undermining the credibility of the central bank to reign over inflation and devaluation.
President Recep Tayyip Erdogan has often made public his preference for lower interest rates, to maintain higher growth. Even on Thursday noon, Erdogan accused the Turkish Central Bank of fueling inflation by raising interest rates, a thesis that defies conventional macroeconomic wisdom. The Lira began to lose ground.
Less than an hour later, the Turkish Central Bank brushed aside the President’s preferences and moved to hike interest rates by an eye-watering 6,25%, from 17,75% to 24%. That was double the market’s expectations and delivered the most significant boost to the Turkish Lira since January, ending a compounding freefall of 40%.
Most significantly, the Turkish Central Bank showed signs of independence.
With double-digit inflation at 18%, the Lira dropped from 3,5 to the dollar in January to a peak of 7,24 in August, and 6,4 this week. By Thursday afternoon, the Lira climbed to just over 6 USD, following a definite streak of good news, including new data that show a shrinking Turkish trade deficit.
The negative spiral or devaluation, triggering inflation, a surge in sovereign yields, and further devaluation may now become more manageable.
The question is how the President will react. Part of the media attention now focuses on a lavish aircraft donated to the Turkish President by Qatar. In August, President Erdogan appeared to be cashing in some favours, securing a $15bn commitment of investment to the Turkish economy. Turkey has been a critical ally to the Gulf State, providing logistical support during the ongoing embargo initiated by Saudi Arabia against Qatar.
Underlying systemic factors
There is one similarity between the Turkish and other emerging market crises. The dollar’s appreciation was caused by higher yields on U.S. Treasury securities. The Federal Reserve is expected to continue hiking interest rates to curb inflationary pressures due to economic growth.
High-interest rates in the US – deemed the safest market in the world – hurt emerging economies in two ways. First, they attract a flow of capital from emerging markets, where investors went to find higher yields given a historically low-interest-rate environment in Europe, the US, the UK, Canada, Scandinavia, and Japan. Secondly, they make difficult for businesses and individuals in emerging markets that have borrowed in foreign currencies, primarily dollars, to service their loans.
Debt in foreign currency amounts to over 40% of the portfolio of Turkish banks. According to the Bank of International Settlements, Turkish banks have issued $148 billion dollar-denominated and €100 billion euro-denominated loans. European Banks that are particularly exposed are Spain’s BBVA, UniCredit of Italy, and France’s BNP Paribas. In many respects, Turkey’s crisis is a European crisis that everyone hopes is manageable.