Turkey is in trouble — again.
At fairly regular intervals, the country finds itself teetering precariously on the brink of a currency crisis, and the root cause is always the same. Recep Erdogan subscribes to an economic playbook that he himself wrote. That would be potentially problematic even if the tenets of his philosophy around FX and inflation weren’t manifestly ridiculous, which they most assuredly are.
Usually, Erdogan’s Houdini-esque penchant for extricating himself from seemingly inescapable economic and geopolitical dilemmas prevails, and I doubt this time will be any different. So predictable is this dance between Erdogan and markets that I generally don’t pay it that much attention until it gets acute. As of Thursday, it’s pretty acute. The lira fell to a record low against the dollar in a harrowing slide through 7.27. The figure (below) gives you some 30,000-foot perspective and context.
Since his installation as central bank chief, Murat Uysal has delivered a total of 1,575 bps worth of easing. Uysal replaced Murat Cetinkaya last summer, after Cetinkaya failed to slash rates fast enough to appease a perpetually impatient Erdogan, whose “unorthodox” economic views generally hold that lower rates lead to lower inflation and, by extension, currency stability.
Inflation has moderated in Turkey and the fact that central banks around the world spent the first half of 2020 slashing rates at a furious pace to help offset the economic hit from the virus freed up room for Uysal to persist.
But it’s not generally advisable to push real rates deeply negative (which is what Uysal did) if you rely on external financing. The annotated figure (below) provides a more granular look at how things have developed.
Exacerbating the situation materially are persistent concerns about the country’s reserves, which have, at various intervals, been the subject of vociferous “debate” between Erdogan and everyone else, including foreign media outlets brave enough to question NATO’s favorite autocrat.
“[We are] under attack by Western media which portray Turkey’s economy as collapsed, finished”, Erdogan railed, during a televised speech in April of 2019, when drama around local elections had markets on edge. He continued: “Oh Financial Times! What do you know about Turkey?”
In a piece out earlier this week, FT explained what it “knows about Turkey”. Here are a few short excerpts:
Speaking last month, President Erdogan hailed a sharp fall in interest rates and praised measures taken to block “malicious” attacks on the Turkish lira. Such steps, he said, were “strengthening the immune system of our economy against global turbulence.”
That could not be further from how most economists see the Turkish picture. The collapse in tourism as a result of the coronavirus pandemic has left a gaping hole in the country’s finances. Foreign investors have fled, pulling out a large volume of funds from the country’s local-currency bonds and stocks over the past 12 months.
In the face of those outflows, the country has burnt through tens of billions of dollars of reserves this year in a bid to maintain an unofficial currency peg – a move that marks a rupture with a two-decade policy of allowing a free float. But, in a sign that those efforts are floundering, the lira last week lurched towards a record low against the dollar even as authorities spent billions trying to defend it.
And so, we’re right back to 2018, only with an exogenous shock (the pandemic) adding pressure.
The common sense solution would be for the central bank to hike rates, but that would be anathema to Erdogan during normal times. The idea of an emergency hike during a crisis is likely to be particularly unpalatable, although he did allow CBT to take steps to stop the bleeding in autumn of 2018.
For now, state banks are blowing through billions to defend the currency and it’s clearly not working. State lenders apparently spent some $2.5 billion on interventions last week alone.
“In the context of a challenging economic recovery, the longer that currency interventions persist, the more reserves depletion will generate its own downward pressure on the currency via undermining investor confidence”, SocGen’s Jason Daw and Phoenix Kalen warned late last month. “And the more difficult it will be for the CBT to retain its loose policy stance”.
The deleterious effects and distortions engendered by panicked efforts to shore up the beleaguered currency manifested in another ridiculous surge in overnight funding costs this week. This has happened before, and the spikes line up with the tumultuous periods marked on the first figure above.
This kind of thing doesn’t happen in a vacuum — it can spill over into equities, for example, if lira liquidity shortages compel foreign investors to sell local shares (or bonds) in order to make good on their end of TRY transactions.
Again, rate hikes could help ameliorate this situation, but as one senior Turkish banker told Reuters, “we do not anticipate a rate rise unless there is no other option”.
Erdogan managed to secure a lifeline from staunch ally Qatar in 2018. In May, Qatar tripled that swap line to $15 billion. Officially, the decision was aimed at bolstering “bilateral trade in respective local currencies and support[ing] the financial stability of the two countries”. But really, it was about further cementing a mutually-beneficial alliance that dates back to the failed coup against Erdogan in 2016. The following year, Turkey supported Qatar when a Saudi-led alliance sought to isolate Doha both economically and diplomatically on the rather hypocritical excuse that Qatar sponsors terrorism.
And it’s not just Qatar that Turkey has leaned on over the past couple of years. In September of 2019, markets learned that Beijing helped prop up the country’s foreign reserves in and around the crucial re-run of the Istanbul election. Specifically, the PBoC sent $1 billion to Turkey under a 2012 lira-yuan swap agreement.
Earlier this year, Erdogan angled to secure a swap line with the Fed, to no avail.
Next up could be capital controls because, as Rabobank’s Piotr Matys puts it, “raising interest rates substantially would be an admission that the strategy of cutting rates well below levels that would be justified by the outlook for inflation and offsetting real negative interest rates with costly FX interventions has failed”.
Right. And Erdogan isn’t a man who is inclined to admit when he’s failed.
It seems likely that he’d sooner double down on FX interventions and employ other draconian measures before he’d countenance a rate hike. And besides, it’s not entirely clear how large a rate hike Turkey would need to change the narrative. In the past, token hikes during periods of currency volatility have been met with an initial knee-jerk, only to see the market quickly fade fleeting lira strength on the assumption that Erdogan would rather die (figuratively) than embark on a serious tightening cycle aimed at restoring market faith.
Ultimately, one imagines Erdogan will figure a way out of this. He’s no stranger to high stakes gambling.