Turkey’s Lira On A Rocky Road

Turkish President Recep Erdogan believes high interest rates cause high inflation and sacked three central bank governors who stalled on rate cuts.

Forecasters who predicted the Turkish lira would fall below 10 to the US dollar by the end of 2021 were wide of the mark. The exchange rate crashed through that psychological barrier in mid-November following a cut in interest rates to 15%—down from 19% at the start of September—after a series of 100 basis point cuts. 

Within 11 days, the exchange rate hit a historic low of 12.93 lira to the dollar, bringing the lira’s three-month decline to 30% and making it the world’s worst-performing emerging market currency—by far. Moreover, the move made the markets wonder about Central Bank Governor Sahap Kavcioglu’s monetary policy. He clearly undertook it at the behest of Turkish President Recep Erdogan, who believes high interest rates cause high inflation. That’s the opposite approach of most other emerging market central banks, which are raising rates to maintain capital flows.

Erdogan said he “was committed to removing the interest rate burden from the backs of our people.” His words likely resonate with the construction lobby, which is close to the governing AKP party. However, most ordinary Turks seem more concerned with declining living standards and high inflation, currently at approximately 20%.

Jason Tuvey, an economist at Capital Economics, says further disorderly drops in the lira’s value will increase wider imbalances and impact banks. His biggest concern is that investor and money market confidence would be so sapped that there could be a “sudden stop” in investor inflows, which happened in Turkey in 2018 and in Russia and Ukraine in 2014 and 2015, respectively. Moreover, Turkey’s current high dependence on short-term capital flows and low foreign exchange reserves make it very vulnerable.

“Turkey is clearly in crisis territory,” says Tuvey. “Without an aggressive policy expense, there is a real risk of large and destabilizing falls in the Lira with the currency bursting through 13 to the US dollar level.”

The Turkish Central Bank hinted that this cut would last for a while. However, Erdogan sacked Kavcioglu’s three predecessors for stalling his interest rate strategy. So investors, like Turkey’s middle class, might be in for a bumpy ride.