Turkish lira in freefall: What triggered the sharp decline?

Jeddah - Yasmine El Tohamy - ANKARA: On Thursday, two years after the historic currency crisis of August 2018, the Turkish lira hit a new record low against the US dollar and the euro despite the months-long failed interventions of state banks and Turkey’s Central Bank (CBRT) to prop up the currency and keep it pegged.

While dollar/lira parity was just 1.31 in 2008 and 2.83 in 2016, it now reached 7.31 on Friday morning, passing beyond the psychological threshold.

The CBRT announced that it is set to use “all available instruments to reduce the excessive volatility in the markets.”

According to experts, Turkey has already run out of ammunition for defending the lira, apart from buying gold to diversify its portfolio.

Last month, the CBRT overtook Russia as the world’s largest purchaser of gold. Turkey’s annual inflation reached about 12 percent according to the official figures.

Erinc Yeldan, an economy professor at Ankara Bilkent University, said that financial investors were leaving the Turkish market after seeing that the CBRT’s reserves reportedly went negative for a couple of weeks.

“They now believe that the king is naked,” he told Arab News, adding that the sharp currency fluctuations might have already benefited some rent-seeking pro-government companies in saving dollars and paying their debts.

For Yeldan, however, such a fixed exchange rate system is like a ship without a rudder — simply unsustainable.

“The reconversion of the Hagia Sophia museum into a mosque despite international warning and the newly adopted restrictions in social media law have been all political operations to divert attention from the economic challenges in the country,” he said.

Regarding macro fundamentals, Nikolay Markov, senior economist at Pictet Asset Management, thinks that Turkey is highly vulnerable given its strong reliance on foreign capital flows to finance its chronic current account deficit.

“Within the Emerging Markets’ space, it is currently the country most at risk after Argentina,” he told Arab News. 

According to Markov, the recently renewed depreciation of the lira reflects investors’ growing concerns about a likely balance of payments crisis, the lack of appropriate economic policy measures and, lately, somewhat higher geopolitical risks.

“The significant decline of the CBRT’s foreign currency reserves due to higher currency market interventions is clearly a trigger, as is the lack of decisive monetary policy actions. To contain the lira depreciation, the CBRT should sharply hike rates now to show its decisiveness and restore investors’ confidence,” he told Arab News.

Pictet Asset Management suggests that the key policy rate should be set now at 14 percent instead of remaining unchanged at 8.25 percent.

Markov also noted that the current depreciation of the lira is not sustainable for a long period given that the CBRT has already lost a sizable part of its reserves and that this has not been helpful in restoring investors’ confidence.

“This actually generates expectations of future CBRT foreign currency interventions, in which case the endgame is for its reserves to be completely depleted,” he said.

For Markov, the best remedy in the short term would be to hike rates aggressively but only for a short period of time to contain the negative impact on domestic demand, which is already largely impacted by the pandemic shock; to reverse the lira depreciation trend; and to restore investors’ confidence and, as a consequence, receive foreign capital inflows into the country.

Nigel Rendell, a senior analyst at Medley Global Advisers in London, thinks that the pattern in the Turkish lira reflects a lack of credibility over economic policy.

“The CBRT is attempting to meet a number of mutually exclusive policy objectives: maintain low interest rates, reduce inflation, promote economic growth and keep the lira broadly stable. Intervening in the foreign exchange (FX) market to try and support the currency and using ‘borrowed’ money from the commercial banks and overseas sources is not sustainable,” he told Arab News.

Rendell noted that many investors began to question the wisdom of the CBRT’s actions when the lira even managed to lose ground against a weakening dollar and concluded that the CBRT was throwing good money after bad to try and keep the lira at an artificial level.

“The problem now is that a weaker currency will quickly feed into higher inflation and threatens to leave the current policy rate looking even further out of line at 8.25 percent. The case for hiking official interest rates is hindered by political constraints,” he said.

“President Erdogan believes in ‘voodoo economics,’ bizarrely arguing that higher interest rates somehow lead to higher inflation,” Rendell said.

Last year, the head of the CBRT was dismissed in an overnight presidential decree over his disagreements with President Erdogan in keeping monetary policy tight.

“So, a rate hike now, at a time when the government is desperate to underwrite the real economy, would be met with political fury. Doubtless, the current CBRT Governor Murat Uysal fears for his job,” Rendell said.

Despite the sharp decline and lira meltdown, the Turkish government still opposes increasing interest rates to prevent a deeper crisis, rejecting the claims that the CBRT’s FX reserves are depleted.

However, according to the official data, the bank’s gross FX reserves decreased from $81 billion to $51 billion this year following the moves to stabilize the currency.

News agency Reuters claimed that the CBRT and state lenders have sold about $110 billion since early last year to fix the lira.

Rendell thinks that, ideally, interest rates should be raised by a couple of hundred basis points, but this looks very unlikely until all other options — like changes in reserve requirements and moderating credit growth further — have been tried, exhausted and inevitably found to have failed.

Sergey Dergachev, senior portfolio manager at Union Investment, believes that the geopolitical challenges in Turkey have been also influential over the free fall and selloff of the Turkish lira over recent days.

“There are still open conflicts with Greece and Libya. Turkey is closely following the Azerbaijan-Armenia conflict, and the situation in Syria is also ongoing. And there are still various open political hotspots between the US and Turkey, like the Russian S-400 missile system and the state-run Halkbank trial,” he told Arab News. 

Dergachev thinks that what investors need would be some signals from the CBRT to calm down markets, maybe by gradually signaling some reversion to a more orthodox monetary policy mix.

“The option to combat this situation with a one-off huge rate hike is there, but political resistance for this ‘ultima ratio step’ is there as well. I do not think that this will calm the situation down fully. Should a rate hike happen, there will be some short-term relief for the Turkish lira and Turkish assets, but investors are looking for more stabilizing macroeconomic and monetary policy-related steps to reduce volatility,” he said.