Friday 15/02/2019

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The Lira sell-off and the laws of economics

The Turkish lira has been stirring up tensions in financial markets. After months of gradual depreciation, the currency’s sell-off has been accelerating. In this blogpost we have a look at what’s happening in Turkeys.



Turkey’s problems have their roots in the past. It has been clear for a while now that the country ranks among the most fragile EM. Its strong growth of late was financed by deficits on its current account. Turkey’s dependence can partially be explained by its reliance on foreign energy imports. The economic expansion was supported by expansive fiscal policy. Yet, changes in the external environment increasingly exposed the vulnerability of the Turkish recovery. Rising energy prices and tighter global financial conditions warranted caution for many EM, but this was particularly true for Turkey given its external financing position. The question was not if, but when the situation would escalate.

It is hardly the first time that an emerging country faces a similar situation, preceding an EM crisis. However, EM are not in the same boat as they were before. Many EM have improved their macroeconomic frameworks, including the use of ample reserve buffers, multiple financial safety nets and flexible exchange rates. Because flexible exchange rates can be volatile and susceptible to self-fulfilling crises, they need to be accompanied by an independent and credible central bank. Turkey’s central bank, however, has not lived up to these standards.

Since the beginning of the year, the central bank failed to increase its interest rates in a timely and material way, despite a falling lira and rising inflation. The failure to prevent an escalation of the situation is even more surprising considering the relative recent experience of the country with a currency crisis. When president Erdogan labelled higher rates “the mother and father of all evil” and made several public statements contradicting fundamental laws of economics, he raised concerns. Suspicions of interference with central bank policy were reinforced. Confidence in the ability of Turkish policymakers dealt with one blow too many when Berat Albayrak, Erodgan’s son in law, was appointed at the head of the treasury and the influence of the president on the central bank increased under the new presidential system. The lira tumbled further, inflation soared and the central bank refrained from acting in a meaningful manner. A trade spat with the US exacerbated the financial crisis.

With the exception of a couple European banks, the sell-off in the Turkish lira remains mostly a Turkish phenomenon. Most EM policymakers, in contrast to Turkey (and a few notable others), do not attempt to challenge the laws of economics at the expense of its citizens. Let’s hope that Turkish policymakers soon change the situation before the economic damage becomes even larger.