What Goes up Must Come Down: The Turkish Lira
In recent weeks and months, the Turkish Lira has suffered severe depreciation against the dollar. After a decade of improvement and growth it seems that the Turkish economy has reached breaking point. The lira plummeted by 20% against the dollar only last week. However, it has also experienced a gradual decline as in the last 12 months it was the world’s worst performing currency depreciating by 50%. No doubt, like us, the Turkish are wondering how and why they find themselves in this crisis and what is being done to lift them from it.
First and foremost it is crucial to understand what exactly is happening to the Turkish economy. The government is running a current account deficit as well as having high levels of debt in the private sector. There is also substantial foreign funding in the banking system. Inflation is running rampant having reached an annual rate of 15.9% exceeding the global average for wealthy nations by over 5 times. There is also an overwhelming sense that the construction sector is teetering on the verge of collapse after years of booming growth, which will most certainly leave banks with crippling amounts of debt. Certainly, this overview paints a bleak picture of the Turkish economy and cannot be the outcome of any single event, but rather a series of decisions and outcomes. What makes it a particularly nuanced case is that there has been both a steady decline and then a sudden and unprecedented drop in the currency’s value.
The reasons for this predicament are both long-term and immediate, political and economic, but can be deconstructed into a few key reasons. Perhaps, in order to understand the reasons for the collapse of the Lira we should also seek the reason its rise, infrastructure. Many have argued that the decline of the Lira was prophesised in Istanbul’s ever-expanding skyline. From a distance these construction sites seem to mirror the modernity of Hong Kong or Dubai however upon closer inspection it becomes apparent that they are half built, barely occupied caricatures of their foreign counterparts.
The issues with the infrastructure mainly arise from the fact that Turkey relies heavily on imports for its raw materials, it being the 9th largest importer of steel globally. This extravagant expenditure has been over 20% of the Turkish GDP for the last 5 years. Moreover, 90% of this construction is funded by foreign loans meaning any depreciation in the Lira severely impacts banks and companies alike. Stark comparisons are drawn between this crisis and the American housing crash of 2008. It is a case of overzealous and uneducated investment facilitated by low interest rates which have led to inflation and overpricing. Typically these spending climates are usually unsustainable and bound to burst, and the Lira is no different.
Of course, had these investments come to fruition this article may not have even been written and we may have been discussing the success of the government’s economic policy. Unfortunately, the investment in infrastructure has been largely fruitless. The alluring profit margins which were promised to investors were largely misguided and there are many instances of people buying real estate before it was completed and those properties were never completed. Indeed the construction firm’s top executives made their money benefitting from the light regulation which has been a signature of Turkey’s economic mantra in the last decade. Moreover, foreign interest in these projects has not met previous expectations. So what remains of the grand vision for Turkey’s infrastructure are ever increasing costs, stalling demand and poor execution.
What exaggerates the problem for Turkey specifically is that as more foreign lenders recognise this issue confidence in the Lira decreases as does its value, in turn the loan repayments (in dollars) become more expensive. This forms a self-sustaining cycle of currency depreciation. A good example of this effect is that the Istanbul Sapphire, Turkey’s tallest building, was built with 164m lira in 2013. If that loan is repaid today it is 539m lira. In the past Turkey has often corrected its foreign currency imbalance with exports, however, as I will illustrate below, this solution has been removed due to the current global political climate. Thus, as nearly 20% of the economy is based upon construction and foreign loans, when the Lira catches a cold the Turkish economy gets pneumonia.
The immediate crash which has been observed in the past few weeks is both easier and yet more difficult to explain. It is simple to explain ‘what’ has happened but ‘why’ would require an intricate understanding of the ideological conflict between the East and West, and the small matter of discerning why Donald Trump does what he does. So for the purpose of this article, I will focus on the ‘what’.
Last month President Trump announced that trade tariffs were to be doubled on Turkish steel and aluminium. The reason behind this sanction is the detention of an American Pastor who is facing charges of espionage and terrorism following the attempted coup in 2016. American conservatives have taken the Pastor’s case prompting Trump’s actions. As foreign investors become more reluctant to take exposure to the Lira, export remains as one of the only ways to improve the foreign currency reserves which are crucial for debt repayments. If the Lira was steadily declining before, Trump’s actions effectively throw it off a cliff. It is imperative to many that the banks do not default as lenders will suffer from liquidity issues leading to a chain reaction and an inability to repay debt. Hence, rapid currency depreciation in a foreign debt heavy economy will have widespread impact as illustrated by the German DAX going down 2% and the FTSE 500 going down 75 basis points on the same day that the sanctions were announced.
Although the above issues are caused by external interference, there is also a degree of blame which should be placed on the government’s policy. Unlike most other nations, Turkey’s leader Tayeb Erdogan controls the central bank rather than it acting independently. He recently cemented his influence by appointing his son-in-law as minister of finance. Aside from the issues with his approach of relaxed regulation, Erdogan’s initiatives are not successfully combatting the issues with the economy. In a time where the government needs foreign investment, the central bank’s restrictions on foreign currency liquidity make it hard to hedge exposure to the ever-weakening lira. Thus while it does stop the number of short-sellers involved in the economy, it could prove to be disastrous if investors continue to lose interest.
Another issue which Erdogan is very firm on is not hiking interest rates to reduce inflation and spending, perhaps he has become overly accustomed to unprecedented growth. He prefers to lower borrowing costs to reduce fuel cost and continue expansion. However, what he may fail to realise is that the more uncontrollably the economy grows the more violently it will collapse. Even increasing interest rates may prove ineffective as evidenced by Argentina’s inability to stop the decline of the Peso despite increasing interest rates to 60%. Could this be another case of too little too late? Only time will tell how Turkey will handle this crisis.
The decline of Lira has been both gradual and immediate. Of course, we could blame President Trump but it seems that this excuse is one which is thrown around too liberally nowadays. The gun was loaded far before Trump came along and pulled the trigger. In fact, the lion’s share of the blame for the Lira’s decline is to be placed on the government’s policies. It seems to be a well-established rule now that unregulated and abnormal growth inevitably leads to disastrous outcomes (see The Big Short). In fact the colloquialism ‘the bigger they are the harder they fall’ rings all too true for Turkey’s current crisis. There is a lesson to be learned here, but it is not one that is new by any stretch of the imagination. Whether it is the tale of ‘Icarus’ or the ‘Tortoise and the Hare’ we as people have known for a long time that manageable and sustainable success is better than booming uncontrollable growth. Yet the eagerness of developing countries to reach new heights blinds governments from these facts and Turkey seems to be the latest casualty of this zeal. Only time will tell how and when the Lira will recover from its current troubles and if Erdogan will learn from this failure.