The Turkish Currency Crisis
International Finance - Fall 2018
Situation Description
Turkey presently has one of the largest current account deficits in the world. This debt, held in foreign currency, coupled with high inflation, and low domestic savings has resulted in the country’s currency crisis.
In 2001, a former World Bank official, Kemal Dervis, became the Turkish economy minister. Dervis’ negotiated a large loan from the IMF in order to help support the growing economy. Other policies that Dervis created were making the central bank more independent from the government (in order to decrease the monetary financing of public spending) and to allow the Turkish lira to float.
In 2003, Recap Tayyip Erdoǧan (the current President) became the Prime Minister, where he was left with the former financial program created by Dervis. The economy at the time was relatively strong, though it had a remaining weakness; a history of high inflation and low savings. In Turkey, the high inflation is interpreted to mean that the interest rates are too low. However, Erdoǧan believes that high interest rates will lead to inflation and not solve the problem. Since his time as Prime Minister and election to President of Turkey, Erdoǧan has managed to convince the central bank to change its monetary policies to suit these views, leading to the lowering of interest rates. The President has also denied that the budget deficit constrains economic growth. This means that Turkey has a reliance on capital inflows to fund the private sector and sustain the economy, leading to foreign-currency debt.
By March of 2018, the foreign-currency debt was roughly equal to about 40 percent of the country’s economic output. This is about double what it was in 2009, with the domestic banks holding almost 80 percent of the foreign-currency debt. This has led to the dollar and the euro more than doubling against the lira under Turkey’s high inflation and the widening gap between the current account and the budget deficit.
The May, there was an sharp decrease in the price of the lira, resulting in foreign exchange bureaus in Istanbul to temporarily suspend trading. This then led to a decrease in the confidence of Turkish consumers and on May 25, an emergency meeting held by the Central Bank of Turkey’s Monetary Policy Committee resulted in the raising of the interest rate under pressure from the financial sector.
At the end of May, the central bank stated that there would be a simplification of Turkey’s monetary policy, coming into effect on June 1, and that there would also be another increase in the interest rate.
In June, manufacturing conditions worsened and the inflation rate continued to increase (from 10.9 percent in May to 12.2 percent in June). After another meeting of the Monetary Policy Committee from the central bank, the benchmark repo rate was increased and this countered market expectations resulting in gains on the lira. At the end of June, the confidence index continued to decline.
In July, the inflation rate continued to climb, to 15.4 percent and consumer price inflation also increased. Due to a substantial amount of debt, international and Turkish banks sought to take control of Türk Telekom, the largest telephone company in Turkey.
Model Implication
Turkish Currency Crisis.mp4Based on the increase in the money supply (and since there is an inverse relationship with money demand) there would be a leftward shift in the LM curve. The interest rates increased along with government spending and consumption, resulting in the rightward shift of the IS curve. The money supply then decreased shifting the LM curve to the left as interest rates again increased. Overall, output increased and the exchange rate decreased.
Assessment
The money supply did increase, peaking at 559184534.70 thousand lira in September where it then has since decreased (to about 522974069.80 thousand lira).
Government spending has increased (though it initially decreased) and a recent decrease in the Consumer Price Index is indicative of an increase in consumption. The interest rate has grown from the beginning of the year of about 7 percent. It was initially increased to 17.5 percent in May and then increased to what it is now, at about 24 percent. The model has held, with the exception of the beginning of December, with an increase in the exchange rate.
Limitations and Conclusion
In regards to this crisis, there are a few limitations. There is a lack of data, due to the fact that this is in large part, still ongoing; policies have only recently been made and therefore the results of those policies in the long run is uncertain.
It must also be taken into consideration that the IS-LM-FX model is a short term model, and therefore does not account for any sudden shifts and with the dependency of Turkey on foreign currencies, the predictions may not hold due to changes in those currencies.
In conclusion, though Turkey has recently increased its interest rates substantially, the lira is still in flux against the dollar, appreciating and depreciating steeply in recent months. While the current account deficit has decreased overall due to a recent [monthly] surplus, what will happen to the lira remains uncertain.
References
The Economist. (2018, May 19). How Turkey fell from investment darling to junk-rated emerging market. Retrieved from The Economist
Note: There is an error for the original link, but article can be viewed on the Wayback Machine
Central Bank of the Republic of Turkey, Head Office. (2018, September). Balance of Payments Statistics. Retrieved from The Central Bank of the Republic of Turkey
Courcoulas, C., & Kandemir, A. (2018, March 29). Turkey's Bill for Debt-Fueled Economic Growth Starts to Fall Due. Retrieved from Bloomberg
Ahval. (2018, July 03). Turkish inflation surges to highest since 2003. Retrieved from Ahval News
Ahval. (2018, June 28). Turkish economic confidence lowest in 18 months. Retrieved from Ahval News
Ozsoy, T. (2018, June 07). Turkey Central Bank Is Latest to Surprise With Rate Increase. Retrieved from Bloomberg
Ant, O., & Hacaoglu, S. (2018, June 04). Turkey Inflation Accelerates in May on Weak Currency. Retrieved from Bloomberg
Ant, O., & Harvey, B. (2018, May 23). Erdogan Surrenders to Market as Emergency Hike Supports Lira. Retrieved from Bloomberg
Ahval. (2018, May 23). Istanbul foreign exchange bureaus close to survive turbulence. Retrieved from Ahval News