The Turkish Lira Crisis Explained
By ARAS URAL | September 23, 2018
On August 10, President Trump announced that the U.S. would double tariffs on Turkish steel and aluminum as punishment for the detention of American pastor Adam Brunson. Although the actual size of the tariffs was miniscule and largely symbolic, within a single day the lira had dropped as much as 17 percent against the dollar, with the lira dropping a whopping 40 percent against the dollar this year alone from 3.8 liras to 1 dollar to a record-low of 7.2 liras to 1 dollar on the foreign-exchange market. As shocking as the developments of the currency crisis have been to those monitoring Turkey’s situation, it is apparent that Turkey’s inflationary and debt-fueled crisis is only just beginning. With inflation that recently topped 18 percent in August, and the refusal of Turkey’s central bank to raise interest rates, the outlook of Turkey’s economy looks increasingly bleak and the possibility of a liquidity crisis on the verge. But how did it get to this point? This article will serve to illustrate how Turkey’s debt-fueled growth strategy and an era of political instability under the Erdogan government has led to the economic malignancy that Turkey is suffering today.
Turkey’s growth strategy for more than a decade was built on debt negotiated in U.S. dollars, financed in large part by Western banks and financial institutions. From the 1990s to 2001, Turkey had been plagued by severe imbalances and a debilitating financial crisis. However, by 2002, Recep Tayyip Erdogan’s Islamist-rooted AK Party (Justice & Development Party) won a plurality and Erdogan was elected PM. Erdogan’s government, with the guidance and assistance of the European Union, International Monetary Fund, and World Bank, implemented major institutional changes and liberal reforms that increased political participation in government, significantly increased productivity growth, and improved institutional structures. Turkey enjoyed five years of rapid economic growth between 2002 and 2007, growing 5 percent a year on average. This cut Turkey’s high budget deficit through the mitigation of public debt by increasing maturity periods and lowering interest rates, as well as greatly diminishing inflation. Turkey’s economic and political reforms, such as granting the central bank relative independence in the setting of monetary policy, were praised by the West and the European Union. These actions inspired investor confidence in the Turkish lira and Turkey was flooded with plentiful credit as Turkey’s economic growth model became dependent on a steady flow of foreign capital inflow to finance domestic consumption as well as investment projects mainly focused in infrastructure development and housing development.
However, by 2007, the economy began to slow down. Productivity growth and Total Factor Productivity growth, an important measurement of efficiency of inputs in generating economic output, began to stagnate. Investment by the government was not allocated to projects that yielded high rate of return on capital to bolster productivity. Lower growth was coupled with higher current account deficits and an even lower national savings rate, followed by falling investment rates. This explains that much of the higher inflows of capital have been mainly financing larger consumption by the public sector, the private sector, and the heavy borrowing by Turkish banks and financial institutions of foreign-currency debts, as opposed to being utilized in bolstering productivity gains. And so, when Turkey continued to ramp up spending and consumption through excess borrowing of foreign currency, despite slowing revenue growth, spending increasingly outweighed revenue, which has created Turkey’s huge and unsustainable growing current account deficit of $51.6 billion in 2018, and a foreign-currency debt to GDP ratio of more than 50 percent.
So why did the inflow of money that powered Turkey’s engine begin to wane? Erdogan and the government of the AK Party that had previously ran on policies of political and economic liberalization began to reverse their reforms. Erdogan, once hailed by the West as a reformist, had since turned his back on Europe by becoming increasingly authoritarian, wielding executive power more reminiscent of that of a dictator than of a democratically-elected President. Erdogan and his party cadre began censoring the media, jailing reporters, lawyers, judges, and political dissidents without due process, as well as jailing generals and military officials while replacing them with bureaucrats loyal to Erdogan to suppress the possibility of a military coup. The current regime has also engaged in widespread graft and bribery, has staunchly decreased investment in public education, committed widespread tax evasion and money laundering, and conspired in massive corruption scandals, including the 2013 corruption scandal in which the director of the state-owned bank, Halk Bank, conspired with Reza Zarrab to violate U.S. sanctions against Iran by smuggling gold into Iran in exchange for Iranian gas and oil. As Turkey became increasingly more unstable, especially following the 2016 coup attempt, investors began to see Turkey as too risky to invest in due to growing political instability and its subsequent failure to protect property rights and correctly monitor and regulate a stable open market economy.
Turkey had, for the past decade, used a low interest rate to depreciate the lira for the purpose of making Turkish goods/services cheaper to spur the export industry. Now, with skyrocketing inflation, a crumbling lira makes it increasingly harder for Turkey to fulfill its dollar-denominated debt obligations. Turkish banks hold debt and face considerable losses if they lack the short-term cash flow to pay it back. Despite outcries from investors and bankers everywhere, Erdogan is adamant to keep interest rates low to spur economic growth, even violating the autonomy of the central bank by appointing his son-in-law Berat Albayrak to governor so that he could prevent interest rate hikes designed to curtail inflation and restore confidence. Currently, the U.S. economy and the stock market is quite strong, and with the Federal Reserve beginning to normalize and raise interest rates, the dollar is further appreciating against the lira, greatly diminishing Turkey’s purchasing power and significantly hampering its ability to service its debts. Even worse, thanks to a strong dollar due to tightening monetary policy as well as the current U.S. bull market, domestic investors are now able to earn higher yields from investing in less risky American bonds and exchange-traded funds, resulting in many pulling investments from overseas investment in emerging markets, which not only aggravates the crisis, but may also lead to further contagion of other emerging markets with exposure to Turkey.
In conclusion, the immediate future for Turkey looks bleak. Turkey seems to be heading towards stagflation – high inflation coupled with a contracting economy. The central bank is currently discussing solutions to reduce foreign capital outflow, such as a decrease on the tax rate on lira deposits, but ultimately, without a significant interest rate hike, Turkey may blindly crash into recession. And while the possibility of contagion – the spread of a shock in one economy spreading out and affecting nearby economies – so far seems relatively minimal, as Turkey only comprises one percent of global GDP, it certainly is possible. While Turkey was recently given a more-so symbolic emergency loan by Qatar of $15 billion, more than $16 billion of debt is maturing in 2019, and the world is anxiously watching if Turkey’s currency crisis will become a debt crisis.