Turkish lira weakness is caused by poor governance

The Turkish lira has lost almost 15 percent against the dollar since mid-March and about 55 percent since the start of 2018, when a currency crisis began sweeping through the economy.

Why is the lira so weak? Why is it likely to weaken further?

The reason is not that the dollar has strengthened; quite the contrary. The dollar fell to its lowest level against major peers since early January on Tuesday. Meanwhile, the lira traded near a record low.

Turkish lira weakness is caused by poor governance in managing the country’s economy and monetary policy. Bad management at the central bank - largely through presidential interference - has thrown a monkey wrench into the way interest rates should be managed.

This trend is not new. A paper by economists Cem Çakmaklı of Işık University and Selva Demiralp of Koç University, cited by Reuters in 2019, documented “a significant decline in the credibility of the central bank in the last decade”.

Çakmaklı and Demiralp found that credibility - defined as the central bank’s ability to slow price increases to its legislated 3-7 percent target range - took the biggest hits when it raised interest rates since late 2016, suggesting investors believed the moves were too timid.

This was likely “due to its weak performance in hitting the inflation target and its exposure to political pressures to cut interest rates”, the academics said.

“Political pressures” came from the Turkish President Recep Tayyip Erdogan. He is a vocal opponent of high interest rates, who has urged more stimulative monetary policies for years, and who publicly opposed rate hikes last year.

The “monkey wrench” thrown in by the president has decimated investor confidence in Turkey. Investment funds withdrew more than $7 billion from Turkey’s local currency bond market in the six months up to the end of June last year - the largest first half yearly drawdown on record, the Wall Street Journal reported at the time, citing data from the central bank. 

“Ankara’s waning economic credibility has already soured the appetite of foreigners, and Turkey could hardly rely on foreign investments to finance its current account deficit as it did in the past. The country’s risk premium is back in the region of 400 basis points, severely decoupled from those of peer countries,” economist Mustafa Sönmez said this month.

The central bank last year spent the equivalent of all of its foreign currency reserves and more - reportedly $128 billion - in a futile attempt to shore up the value of the lira. The result is that the reserves - net of liabilities - stand at almost minus $50 billion.

The lack of confidence in Erdogan’s direction of the economy has led local savers to turn to hard currencies to protect their savings against the depreciation of the lira and inflation. The risk of dollarisation has hardly abated, as evidenced by the fact that 57.4 percent of individual deposits in Turkey are in foreign exchange, amounting to $159 billion, Sönmez said.

There are two looming menaces that may push the value of the lira down further: a U.S. taper and rising commodities prices.

There has been a temporary jump in inflation in the United States, and with it comes the risk that the Federal Reserve could raise rates. Should that happen, investors will pull funds out of emerging markets - including Turkey - and invest them in the ‘safer’ United States. This would hurt both Turkey’s current account and the value of the lira.

The second menace is more probable and more dangerous: rising commodities prices are likely to drive up the cost of energy and goods in Turkey, pushing the inflation rate higher. If this happens, and the central bank does not act, the value of the lira will plummet.

Such is the penalty for poor governance of a major economy over a long period. And we know who is to blame.

The opinions expressed in this column are those of the author and do not necessarily reflect those of Ahval.