The Decline in Turkish Lira and Its Impact on Global Financial Markets
Turkish President Recep Tayyip Erdoğan seems to change his central bank governors like Prince changed his name. Naci Agbal, The Artist formerly known as the key force in pulling the Turkish currency back from historic lows, was replaced last Saturday marking the third exit of a central bank governor in two years.
This change in bank governance has led to the Lira diving as low as 17% against the US dollar at the start of a new trading week. This also adds to the existing problem of diminishing foreign reserves and a weakening currency that has been pushed to sub 8.00 against the dollar (USD/TRY is at 7.91 at the time of writing), one of its worst values in history.
But why is the Turkish Lira moving the way it is? And what lessons does it bring for the rest of the world?
The Turkish Currency and Debt Crisis
Turkey is a well-developed industrial economy with an educated workforce. However, one of the longstanding characteristics of its economy has been a low savings rate and one of the largest current account deficits in the world ($62bn as of October 2020, rising 34% YoY).
Translation: the country sells a lot of Liras to buy what it needs (i.e. Imports).
That naturally implies that banks and big corporations resort to borrowing heavily in foreign currencies as well, significantly enhancing their risk profiles.
Think about it…if you borrow in USD but pay interest in Lira…things can quickly fall out of whack when the Lira depreciates, resulting in widening deficits and a systematic ballooning of debts.
Following the attempted coup in 2016, the Turkish administration went into a distrustful regime, often seizing foreign-owned assets that were suspected of playing a part in the coup. These measures, coupled with political instability, friction with the USA (and other Western nations) have slashed capital inflows into Turkey and expanded foreign currency debt.
Role of Erdoganomics
President Erdogan has famously propagated the idea that high interest rates cause higher inflation (even tagging interest-based banking as “prohibited by Islam”), a theory that flies in the face of conventional economic theory elsewhere.
In an effort to supplement this unorthodox policy, Mr. Erdogan appointed his son-in-law Berat Albayrak as the finance minister in 2018. During his tenure, there were a string of interest rate cuts leading to a credit binge and rising inflation (running above 15%). The Lira shed its value by half. This, in turn, led to the central bank enforcing a backdoor tactic to stabilise the currency — by having state banks sell close to $130bn in dollars, which further depleted Turkey’s forex reserves.
Mr. Albaryak resigned in November 2020 owing to a declining Lira and increased public scrutiny. Following this, Mr. Naci Agbal was brought in as the governor to remedy the situation, which he successfully did by hiking rates sharply, controlling inflation and helping the Lira regain its value by enlisting a net $20bn in foreign investment into Lira assets, reversing years of outflows.
However, his strategy to raise interest rates played foul with the President’s interests(pun intended!). Some view his exit as symbolic of a lost battle aimed to implement a tighter monetary policy against an unconventional credit-based economic model. A model that would be built at the cost of rising inflation and falling currency.
How a Mercurial Lira Affects Markets?
Mr. Agbal’s five-month stint marked a turnaround in the market sentiment towards Lira which had been facing a downturn for so long. This change towards a bullish forecast in the currency worked well with Lira’s easing volatility which was used by forex traders to indulge in interest rate arbitrage.
Arbitrage, in plain terms, means a kind of trading where the trader profits from discrepancies in prices of financial instruments (e.g. Currency). One of the ways in which currency arbitrage is done is by exploiting the interest rates in different currencies. This is also called carry trade i.e. borrowing funds in a low interest rate currency to invest in a high interest rate currency.
The Lira climbed back by 3.1% this year, beating all other emerging market currencies. This led to forex traders betting on a rebound in the Lira from its past lows. Shortly before Mr. Agbal’s exit, Turkish central bank increased rates by a massive 200 points (to 19%), presumably as part of a strategy designed to curb inflation further and support the convalescent Lira.
But, his departure has now come as a shock to the markets and a dent in the above-stated presumption that the Turkish economy was back to implementing conventional policy measures, including a strengthened interest rate regime. The “Lira Bulls”, therefore, are now faced with uncertainties in the forex market for banking on a possible growth in the currency.
Turkish Troubles Spelt For Other Economies?
Shortly after the 2018 currency crisis sparked in Turkey, a popular discourse centred around the word “contagion” spread across the world.
Currency fluctuations in Turkey have most significantly affected the Japanese markets where retail investors have taken long positions on erstwhile high-yielding Lira traded on the Tokyo Financial Exchange — Japan’s primary futures exchange dealing significantly in currency and derivative trades.
The uncertainty also comes at a time when the biggest macro theme across the world has been rising inflation (or expectations of rising inflation). While it is the US inflation trends which are most closely watched, emerging markets such as India also seem to be somewhat battling the interest rate-inflation conundrum. But a tanking Lira, in all likelihood, has a fairly muted direct impact on the much stabler and structurally sound RBI (and the INR).
There is, however, a caveat — India and Turkey often get clubbed together into the wider “emerging markets” bucket in several investment models and mandates which carries the risk of some sort of spillover effect. This could get exacerbated by a general circumspect sentiment for emerging markets all across. But there are limited signs of such a Turkey-India equivalence. However, on the flip side, one could also expect higher capital inflow into India at the expense of Turkey.
Given the politico-economic nature of this currency movement and the several moving pieces at play, assessing the direction and quantum of impact is fairly hard.
(Originally published March 23rd 2021 in transfin.in)
