Currency crash: The case of Turkish Lira

Turkey is in the throes of a currency crisis. The lira has lost more than 40 percent of its value against the United States dollar in 2021, making it the worst-performing of all emerging market currencies. The status of a currency may be equated to the de facto sovereignty of a country. However, with the Euro as the single currency of the 19 out of 27 countries of the European Union, the strength lies in zero transaction cost constituting over 70 percent of the total trade among the member states; the European Central Bank performs the task of consolidation of sovereignty through its rigid monetary norms. The sanctity of a currency is maintained through pragmatic monetary policy embedded in the independence of the central bank of a country. Several variables such as interest rate, growth of domestic credit, the debt as a percentage of GDP, the extent of the budget deficit, and differences of foreign interest rate work together in the reinforcement of the currency. It is not inimical for the balance of payments accounts when the drop-in par value of a currency wavers in a narrow range yet a currency crash often causes havoc in macroeconomic management.

A currency crash depicts a large change in the nominal exchange rate that accompanies a substantial increase in the rate of change of nominal depreciation. Crashes are the result of an abrupt cut in the domestic interest rate, stagnation in GDP growth, higher growth of domestic credit, and a higher level of foreign interest rate. A low ratio of FDI to sovereign debt and a higher percentage of short-term capital flow are also associated with a higher likelihood of a crash.

There are many instances of currency crashes in economic literature; the Turkish lira crisis of 1994, 2001, and 2018; the collapse of the Mexican peso during 1994-95; and the East Asian financial crisis during 1997-98. These upheavals witnessed the drastic drop of the nominal exchange rate of many currencies including Thai baht, Indonesian rupee, and the Philippines peso. It appears now that Turkey is on the footprint of this Asia's somber era that erupted in the financial crisis of several east Asian countries two decades ago. There the large inflow of short-term capital denominated in foreign currency and incongruous to foreign exchange reserves worked as a death trap. The currency par value dropped once the outflow started due to loss of confidence spurred through persistent depreciation. This hurts the real economy and further reduces confidence, leading to a further decline in the currency. The Turkish lira has been plunging to all-time lows against the US dollar and the euro for a couple of months and lost over 40 percent of its value since the beginning of the year, 2022.

The immediate impact of currency crashes is reflected in consumer price but unfortunately, President Recep Tayyip Erdogan presses ahead with a widely criticized effort to cut interest rates. He sacked both the central bank governor Naci Agbal and one of four central bank deputy governors Oguzhan Ozbes in a gap of two months on March 20, 2021, and May 25, 2021, respectively. The argument for the low-interest rates is to stimulate the economy, augment export earnings and create jobs. However, the government’s unorthodox policies are fueling inflation as against the conventional rule that a high-interest rate eases inflation. Consumers are struggling to buy food and other goods. The early years of Recep Tayyip Erdogan witnessed an excellent macroeconomic performance that helped him to win several elections and now this is the nineteenth year of his presidency. Theoretically, a rate cut is justified in the face of stymied inflation but with inflation above 30 per cent (according to the independent inflation Research Group estimate exceeding 58 percent) the rate cut of 4 percentage points since September is considered to be pro-cyclical aggravating the price spiral.

Moreover, the rate cuts have raised concerns over the central bank's independence, while the country's unconventional monetary policy has unnerved foreign investors, who are dumping Turkish assets and natives are rushing to convert their savings to foreign currencies and gold to protect them from soaring inflation. Surprisingly, more than half of locals' savings are in foreign currencies and gold owing to a loss of confidence in the lira after years of depreciation.

A new financial alternative by the government to convert FX deposit account into a lira account with an incentive may ease the burden on the lira but it essentially depends on the foreign exchange holding and future foreign exchange inflow. The incentive covers the gap after interest rate and exchange rate difference at the opening and closing of lira deposit accounts manifested in the interest parity theory. The account owner will be paid whichever is the highest. The accounts that are converted to lira deposit accounts can have three, six, or 12-month maturities.

The drive to save lira by selling foreign reserves may boost the lira value and indeed lira surged more than 50 per cent in the last week of December 2021 following billions of dollars’ worth of market interventions. The rate was USD 1 = 16.69 TRY on December 19, 2021; on December 26, 2021, 1 USD= 9.96 TRY but on January 4, 2022, 1 USD = 13.35 TRY. The variation in rate within two weeks represents extreme fickleness of par value. However, the buoyancy depends on the holding of reserves. A country can only embark on the massive sale of foreign currency reserves when blessed with excess reserves; the reserve holdings of USD 165 billion in 2018 worked as a buffer during this intervening period but currently, with the reserve holdings of USD 7.26 billion the lira safeguard may be a challenge for the central bank.

The trade intensity of Turkey with a population of 85 million and GDP of USD 750 billion (USD 2.873 trillion in PPP) is over 60 per cent; export and import as a percentage of GDP are within the threshold of 30 percent. The deficit in the trade balance is accommodating but the foreign exchange reserves should be at least about USD 68 billion; worth three months of import payments. However, currently with a reserve of a paltry USD 7 billion, it would be difficult to safeguard the value of the lira. All these statistical twists could be lessons for many developing countries including Bangladesh.

The writer is the Treasurer and a Professor at the School of Business and Economics, United International University. He can be contacted at obaidur@eco.uiu.ac.bd