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What is needed to support the Turkish lira?


The plight of the Turkish lira is back in the headlines this week. The currency sank by 15% against the US dollar at one point on Tuesday to reach a fresh historic low of almost 13.50 to the US dollar. Despite a modest rebound since, the lira has depreciated by close to 40% so far this year, as at 24 November, leaving it firmly at the bottom of the performance charts.

The background to the latest lira weakness

Market participants in Turkey are well accustomed to periodic sharp sell-offs in the currency. The country has effectively been playing a long-running game of cat and mouse between its structurally poor balance of payments, political pressure to lower interest rates, and investors’ willingness to fund deficits. Indeed, the markets went through a similar experience earlier this year after central bank governor Naci Agbal was sacked and replaced with government-ally, Şahap Kavcıoğlu.

The lira’s fundamentals had actually been looking relatively ok. Monthly current account readings had been springing positive surprises while a deceleration in real credit growth suggested that the trend would continue for a while longer.

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However, all of that was thrown out of the window once political pressure ultimately forced the central bank to begin lowering interest rates in September. The policy rate has already been cut by a total of 400bps, taking it negative in real terms, while President Erdogan’s declaration on Tuesday of an “economic war of independence” implied that more unorthodox policy is on the way.

What could Turkey do to stabilise the lira?

Such exponential sell-offs have in the past often required aggressive interest rate hikes in order to protect the capital account, stem outflows, and stabilise the currency.

For example, in 2018 a succession of rate hikes totalling more than 1000bps were ultimately required to bring a similar sell-off to an end.

However, President Erdogan’s comments appear to rule out what would amount to a major U-turn in central bank policy. At least, until or unless market conditions get even worse. Further pressure on the currency may well materialise. Even so, very large interest rate hikes in excess of those seen in 2018 would probably be required for the market to gloss over the latest heavy blow to the central bank’s credibility.

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For the time being, that leaves two options: let the currency go, or impose capital controls to prevent further depreciation. Much will probably depend on just how much more pressure the currency and local banks’ holdings of foreign exchange come under.

There have now been at least a couple of periods, in 2018 and during the Covid crisis last year, where question marks have been raised about the convertibility of the lira. The authorities imposed restrictions on access for foreign banks to the lira market, and the ability of locals to exchange lira for foreign exchange.

We would not be surprised to see these measures imposed again as the government attempts to ride out the storm. And while outright capital controls would be self-defeating in the long run, and therefore unlikely, the steady deterioration in policymaking makes the threat greater than in the past.

Is there a contagion risk to other emerging markets?

In short, no.

The current problems in Turkey are very much self-inflicted, as opposed to a sign of structural problems elsewhere. Indeed, virtually all other EM central banks are busy hiking rates to rein in inflation, potentially setting up opportunities next year.