Erdogan’s dangerous lira game

The Turkish President is once again unsettling the financial markets. From an economic perspective, Erdogan plays with fire. A “death spiral” threatens the Turkish economy.

From Angela Göpfert, tagesschau.de The next lira crisis is here. On Thursday, the Turkish currency fell to $ 0.1204 – a drop of 1.4 percent. The day before, the lira had lost 1.0 percent against the dollar. The losses against the euro are similarly high. These are truly extreme movements for the foreign exchange market, where fluctuations usually take place in the per mille range. The sharp fall in the lira follows an economic policy on the part of the Turkish president that is perceived as extreme on the financial markets. Once again, Recep Tayyip Erdogan unsettled the financial markets with drastic statements: Turkey is in a fight against a “triad of evil” consisting of inflation, interest rates and exchange rates, according to the head of state.

The Turkish lira is clearly on a downward trend against the US dollar.

Not the first Fed chairman to be laid off

It was only in March that Erdogan had the governor of the CBT central bank, Naci Agbal, dismissed by presidential decree after he raised the key rate from 17 to 19 percent. Less than three months earlier, Erdogan had promised to accept the “bitter pill” of high interest rates to curb the rapidly galloping consumer prices. Erdogan seems to have changed his mind. Because Agbal’s successor is Sahap Kavcioglu, a former AKP MP and proponent of low interest rates.

Monetary policy credibility ruined

Due to several changes in personnel at the top of the central bank, the lira had already lost considerable ground in recent months. However, experts doubt that a weakening of the central bank’s credibility is the right answer – and they also choose drastic words. Erdogan is risking “seeing another lira crisis,” warns Tatha Ghose, Commerzbank’s London-based foreign exchange market expert. With his “de facto ban on sustained high interest rates” he ruined the credibility of monetary policy.

Capital controls as a last resort?

Against this background, Turkey does not really have anything to counter the rapidly rising inflation. In March, the Turkish inflation rate was 16.2 percent. Erdogan then announced the goal of an inflation rate in the single-digit percentage range.

Consumer prices are a long way from Erdogan’s target of a single-digit inflation rate. Some experts are now counting on the introduction of capital controls as a last resort to stop the unchecked outflow of capital from Turkey. Comprehensive controls are unlikely to be expected, however, as Turkey is simply too dependent on foreign capital for that. In addition, a ban on the free movement of capital would completely ruin the confidence of the financial markets in Turkey. Support purchases of the lira on the foreign exchange markets are also likely to miss their target in view of Turkey’s extremely thin cushion of foreign exchange reserves.

Experts warn of a downward spiral

The weak Turkish lira poses immense dangers for the Turkish economy: “Devaluations of the lira are always important because the currency-related spill-over effect contributes significantly to the high Turkish inflation,” emphasizes foreign exchange expert Ghose. “Any movement, however inconspicuous, can trigger a new market spiral and complicate the situation.” As early as 2018, Nobel laureate in economics Paul Krugman warned of a “death spiral” for the Turkish economy. At the time, he also explicitly named domestic events as possible triggers, such as repeated attacks on the independence of the domestic central bank.

Paul Krugman warns of the risks of a decline in the lira. Image: dpa

First the financial markets, then the real economy

The direct consequence would be: The domestic currency rushes into the depths. This increases inflation, as many goods for expensive money have to be imported from abroad, which in turn increases the cost of business and the cost of living for many Turks. The decline in the lira is also making it more difficult to repay debts in foreign currencies. Many Turkish corporate bonds and loans are denominated in foreign currencies such as dollars or euros. There is the next downward step: Turkish companies go bankrupt. Then unemployment rises, domestic consumption falls – the crisis has a full impact on the real economy. The logical consequence: investor confidence continues to decline. This in turn puts the Turkish currency under greater pressure – and the downward spiral begins again.

Lira expiry without end?

Krugman’s warning is as relevant today as it was in 2018: then, as now, it was the “unconventional” monetary policy worldview of the Turkish president that created the expectation among market participants that sustained high interest rates would not be enforceable in Turkey. It is these expectations that weigh heavily on the lira. An end to the lira downward spiral – apart from short-term recovery phases – does not seem in sight for the time being. Experts such as foreign exchange market analyst Ghose expect the Turkish currency to decline further. According to his forecast, investors will have to spend ten lira for one US dollar in December 2021. However, this is more of a “symbolic” forecast as Turkey is currently venturing into uncharted monetary policy territory. This makes a rational exchange rate forecast virtually impossible.

IMF regime as a way out?

The fact is: the lira is currently trading at $ 8.26. The further “symbolic” downside potential for the lira by the end of the year is therefore a proud 20 percent. According to experts, the only possible way out to prevent such a scenario would be a rescue package from the International Monetary Fund (IMF). This could help restore the credibility of important institutions such as the Turkish central bank in the market. Erdogan has so far rejected such an IMF program because it would undermine his personal power.