Turkish lira falls apart, what can turn the tide?

2023年6月29日，GMT下午2:07- Marios Hadjikyriacos

The Turkish lira has gone into freefall, losing more than 20% of its value in the last month alone. Plagued by artificially low interest rates, extremely high inflation, and a shortage of FX reserves, there isn’t much on the horizon that can change the lira’s fortunes. A short-term recovery is possible after such a dramatic fall, but the broader trend remains overwhelmingly negative. 

Lira breaks down

It has been a devastating month for the Turkish currency. After President Erdogan emerged victorious from the recent elections, the lira resumed its vicious downtrend in full power, crushed by fears for another five years of unorthodox economic policies. 

Before the election, the Turkish central bank was intervening in the FX market to support the lira, depleting most of its reserves in the process. With the election out the way, the interventions stopped and the lira was left at the mercy of market forces. 

That’s only half the story, though. Another element that ravaged the lira was the central bank’s latest decision on interest rates. With a new governor coming in, there was rampant speculation about a massive increase in rates to fight runaway inflation. 

Some economists expected rates to be raised immediately to 25%, so when the central bank only lifted them to 15%, investors saw that as a huge disappointment. With inflation running around 40%, this move was seen as a ‘half measure’ that won’t be sufficient in cooling the economy down. 

Behind the downtrend

Taking a step back, the lira’s downtrend is not a new phenomenon. The currency has been in decline for more than two decades, although the losses accelerated sharply after 2018 as inflation started to fire up and the nation’s deficits blew up. 

When inflation moves far higher but interest rates don’t follow suit, the result is that real interest rates fall deep into negative territory. That’s toxic for the lira because it discourages investors and consumers from holding it. Nobody wants to keep a currency that is constantly losing its value, if they are not compensated through high interest rates. 

Many have attributed the central bank’s reluctance to raise rates to political pressure from President Erdogan, who has characterized high interest rates as “the mother and father of all evil”. The fact the central bank has changed its Governor four times over the last five years is a testament to this political arm-twisting, as Erdogan simply replaced any leaders that dared to raise rates much. 

Therefore, it can be argued the central bank has effectively lost its independence, leaving it unable to take the actions necessary to extinguish inflation. Even the new governor - who has a background as a Wall Street banker - could not break this spell. 

Making matters worse for the lira, Turkey runs a chronic current account deficit, which has swelled in recent years. That means the nation is a net-borrower, importing more than it exports and relying on capital flows from abroad to finance the difference. Over time, these deficits can exert massive downward pressure on a currency, especially if they keep widening. 

The government has tried all sorts of unconventional tactics to stop the lira’s bleeding, such as making it more difficult to short the currency, introducing special savings accounts that compensate consumers if the lira falls sharply, and de facto confiscating foreign currencies from private banks to boost its FX reserves. These moves helped slow down the pace of depreciation for some time, alongside regular FX interventions, albeit at the cost of draining reserves. 

What’s next 

Looking ahead, there isn’t much that can turn the tides in the lira. What the currency desperately needs are higher interest rates, to slow down nominal growth and eradicate inflationary pressures, a painful process that will most likely involve a recession. Yet, President Erdogan seems determined not to let that happen. 

Slashing government spending could help to lower inflation, although this strategy might still be bearish for the lira initially, given its negative implications for economic growth. Plus, fiscal austerity would be a wildly unpopular move politically, making it seem even less likely. 

That leaves structural reforms and regulatory changes, but admittedly, it’s highly doubtful any such policies would be powerful enough to rescue the currency. If there were easy solutions from a legislative perspective, they would have been implemented already. 

As such, it’s difficult to see a path towards a sustainable FX recovery, at least under the current political leadership. While a near-term correction seems plausible after such a dramatic downfall, it is unlikely to go very far, with real rates so deep in negative territory and FX reserves exhausted.