The lira’s freefall: How much lower can it go?

U.S. sanctions against Turkey in response to its ongoing detention of American pastor Andrew Brunson are, in principle, only the tip of the iceberg. Potentially more damaging sanctions could be just around the corner and other economic factors are contributing to the lira’s free fall.

Investors are following the situation closely and are anticipating the inevitable crash of the mismanaged Turkish economy. As seen in the graph below, the rate at which the Turkish lira has diverged from the currencies of other developing markets is terrifying. 

Turkey inflation emerging markets

Neither Treasury and Finance Minister Berat Albayrak, nor head of the central bank Murat Çetinkaya have even attempted to make statements to calm the markets in response to the imposition of U.S. sanctions on two Turkish ministers on Aug. 6, a “Black Monday” when the lira rate crashed to as low as 5.42 to he dollar and the 10-year compound interest rate simultaneously rose to 20.09 percent. 

The central bank chose to put out the fire using only a $2.2 billion reserve option mechanism (ROM).  This decision again degraded the perception of the central bank in the eyes of investors to an institution that has little or no control over interest rates. The problem is much bigger than just dollar liquidity or interest rates. Trust in the central bank has fallen to its lowest level because the institution has failed to call an emergency meeting in response to Black Monday, its unrealistic revision to year-end inflation of 13.4 percent and its failure to directly address the ongoing market uncertainty.  

The overreaching issue alarming investors is the de facto one-man rule of President Recep Tayyip Erdoğan and his micromanagement of all aspects of the economy. Investors now see the president’s disturbing statements to Bloomberg TV in May, in which he pledged to lower interest rates after the June 24 presidential elections, being implemented and increasingly believe that the whole of the Turkish economy is no longer in capable hands, but controlled directly by the whims of Erdoğan and those close to him.

Turkey’s economic indicators are just as fragile. The lira’s recent sharp decline is, of course, due to a range of underlying economic problems. Arguing which factors are most important is no longer meaningful. As one can see, the overall combination of factors has created a perfect storm.

But naturally, inflation which has already started to increase towards 20 percent from the current 16 percent, and the threat of faster price rises is not being taken seriously by the government.

Neither is it taking seriously critics who warn that if monetary policy does not change, the lira could slump and destroy the economy. But its decline is now out of control and threatens every balance in the economy. The central bank, which has maintained a loose monetary policy to support the government’s high growth targets, is largely responsible. Within the global economic order, capital demands higher interest rates as inflation accelerates. But if the policy interest rate is lower than inflation or the benchmark bond rate, that means a drop in value for the currency.

There is a vicious circle where the currency devalues, stoking inflation, because the central bank, with its hands tied politically, cannot make the necessary adjustments in advance. This, in turn, reduces real interest rates - the difference between interest rates and inflation - and another round of devaluation begins.

Turkey CPI vs core

A high current account deficit is yet another indicator of a malfunctioning economy which fuels currency devaluation. In simple terms, the current account balance shows a deficit (or surplus) between a country’s foreign currency income and foreign currency liabilities. Turkey’s account deficit is around 6.5 percent of its GDP. While this is not the highest percentage in history, the ratio is widely seen by experts as unsustainable within the context of current international norms.

For the past several years, Turkey’s overheating economy was fuelled by directing cheap foreign resources to consumption. At present, however, this money is fleeing Turkey and this further pushes down the value of the lira and impacts economic growth. The resulting recession will decrease the current account deficit. However, as real structural improvements to the economy have not been made by the government over the past 10 years, the situation causes most investors to think any improvement in the deficit will only be temporary.

Turkish current account

Another issue that goes hand in hand with the current account deficit is, of course, the external debt of the private sector. The fact that half of the private sector’s external debt is in foreign currency, coupled with worries about how that debt is going to be repaid, puts more pressure on the lira. Companies the government allowed to borrow money abroad without restraint, when foreign money was cheap, have now started to quickly lose out. The $25-30 billion pile of debt restructuring that banks now need to deal with the issue will become even larger as the lira loses more value. And in such an environment, where banks start worrying about their capital and investors become more and more concerned about their capital, a vicious circle will once again work towards devaluation for the lira.

Turkish external debt stock

We should also briefly look at public finances. The fiscal deficit to GDP ratio, which was in double digits after the 2001 crisis, was consequently pulled back to less than 1 percent, keeping Turkey’s risk premium at a low level for many years. Now the ratio is moving towards 3 percent and the government is widening the fiscal deficit to fuel growth.

Even though Albayrak frequently speaks about austerity, the feeling is that these planned savings are geared towards meeting the spending scheme outlined in Erdoğan’s 100-day plan announced last week. So guess what this increase in the deficit, which increases inflation, hits the most?

Turkish central government primary balance

Despite everything, there are ways to break this cycle. But because it requires fundamental changes in the approach of the government, it seems impossible. Still we should heed educated recommendations. Mahfi Eğilmez, a well-known economist in Turkey, summarised the structural reforms he says are needed:

“The legislative, executive and judiciary to become independent from each other, science to be dominant in education, subsidies to be used correctly, production to be directed through R&D adjustments and the current account deficit to be lowered. The central bank and other independent institutions should be “really” independent. Shifting the weight on indirect taxes onto direct taxes in order to bring justice to the tax system. Transparency and complete supervision of all public spending and revenues.”

But in order to reach the point where Erdoğan is ruling as an all-powerful president, the government has moved in the opposite direction. How realistic can it be right now to expect a complete reversal overnight?

Meanwhile, the government’s 100-day plan is based completely on spending. Is it therefore really possible to expect cautious and disciplined financial reform programme from the government’s Medium-Term Fiscal Plan, the announcement of which is now delayed until mid-September? It is hard to be optimistic.

The crash in Turkey, which we have been watching in slow motion, is gaining speed. Years of economic mismanagement and the huge imbalances it has caused had already caused much devaluation of the lira long before 2018. But now the reality is no longer concealable. As long as there is no return from dreamland to the land of reality, as long as Turkey does not become a country governed by law, the lira’s free fall has no end.  

Turkish central bank reserves

However, there is a stopping point for the damage a devalued currency can create for any economy. It is called the joint bankruptcy of the private sector, regular people, banks and of course the public sector. And it does not seem like we have much time until March 2019 elections.

After that will come the years when the International Monetary Fund will come along with at least $50-60 billion and strict adjustments that will return Turkey to the same playing field as the rest of the global markets. The lira will then gain some value and there will be years of low growth rates.

One cannot help but hope that Erdoğan’s party, which took charge of Turkey after the 2001 crisis, would have learned a lesson or two from it extended period in power. But it seems they did not.