The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
Having tried to defy internal and external economic logic by repeatedly cutting interest rates, Turkey opted this week for a new set of unorthodox measures to stabilise its currency.
Whether the authorities are more successful ultimately this time around boils down to a simple question: will Turkish households and companies view this “circuit breaker” as a bridge to a more comprehensive set of measures that address the underlying drivers of economic and financial instability or, instead, as a destination that soon proves inherently unstable?
It is hard to put into words how disorderly the Turkish currency markets had become by Monday afternoon. The lira had weakened to beyond TL18 per US dollar, constituting a halving of its value in just two months.
The rate of depreciation was gathering momentum, as was the chaotic nature of the trading even though the central bank was intervening, thereby depleting further its international reserves.
It was just a matter of time until all this also led to another leg-up in an inflation rate already above 20 per cent. A growing part of the population were opting to protect their savings by changing lira deposits into dollars and other hard currency (what economists refer to as “dollarisation”).
The proximate cause of all this was the 5 percentage points cut in domestic policy rates since September at a time when both internal and external conditions called for a hike. Inflation was rising, the currency was under pressure and global monetary policy conditions were starting to tighten, especially in the emerging world.
Desperate for a circuit breaker, the authorities opted this week for a set of complex measures that are best described as an interest rate equalisation mechanism with guarantees to maintain the real value of lira deposits when measured in hard currency.
In addition to lowering the incentive for further dollarisation, this approach appears to have three side-benefits of interest to the Turkish authorities. First, it avoids the impact of a partial and implicit interest rate hike on the rest of the economy. Second, because the guarantee applies to 3-12-month deposits, it encourages the lengthening of the average duration of such deposits. And third, it helps alleviate heavy and mounting inflationary pressures.
All this at a time when, prior to the announcement, the currency was trading in “overshoot” territory according to most economic measures.
These advantages come with considerable risks. The mechanism exposes the fiscal accounts/central bank to a large financing burden unless other measures are taken to control inflation and limit renewed pressures on the currency away from dollarisation. If the mechanism fails, it will further undermine the credibility of policymakers, making it harder for the next set of measures to take hold quickly even if they are comprehensive and appropriate.
It is the still-large set of Turkish lira depositors who, within weeks, will determine the outcome. If they trust the policy response and worry little about the potential collateral damage, they will encourage others to buy the domestic currency, domestic and external. The government can help this process by credibly signalling that the latest measures are not an end in themselves but rather a bridge to a more comprehensive set of policies.
This would include explicit rate hikes by the central bank which, at this point, are still necessary but no longer sufficient. Turkey will also need to seek other internal anchors, such as a tightening of fiscal policy, and perhaps also external ones, such as agreement on an IMF programme that provides both funding and external validations.
All this will need to be done while avoiding the understandable temptation of capital controls that would undermine a historically powerful, and still impactful open growth model that, both economically and financially, exploits Turkey’s many “competitive edges”.
Through a new set of unorthodox measures, Turkey has bought itself artificial stability. This is unlikely to translate into genuine stability unless Turkish citizens are convinced that their currency crisis has truly passed.
This only happens if the government quickly shifts to a more comprehensive — and, yes, more orthodox — policy approach. Failing to do this would further erode the country’s strong economic attributes. After all, there are limits to continuously defying the laws of both economics and finance.