Turkey nears tipping point: capital controls, use of reserves unlikely to prevent lira depreciation
By Dennis Shen, Director, Sovereign and Public Sector Ratings
The government in Ankara has few options available so long as President Recep Tayyip Erdoğan remains committed to lowering borrowing rates to accelerate economic growth and raise exports even under conditions of inflation of above 20% – eroding ordinary citizens’ disposable income.
Either the currency crisis gets bad enough and the central bank belatedly hikes rates to ease current selling pressure on lira and check inflation or the central bank resorts to ‘de-globalising’ the currency. That would involve reintroducing capital controls, limiting access to foreign currency within the economy, seeking foreign currency from domestic banks and foreign allies, and going through reserves to defend the currency, in line with what occurred between 2018 and 2020 when Erdoğan’s son-in-law Berat Albayrak ran economic policy.
Any decision to cut rates further, as other global central banks are meanwhile tightening, at the monetary policy committee of 16 December could place even further pressure on lira, already having lost around half its value since February.
Inflation rose to 21.3% YoY in November, sending real policy rates to -5.2%, among the lowest in emerging markets.
Stemming the lira slump is critical but the government’s exchange-rate pain threshold seems higher than it was in 2018 or late 2020 when the central bank last hiked rates sharply to circuit break a currency rout.
Erdoğan has significantly consolidated his influence over economic decision-making, including monetary policy. The president appears much more entrenched during this crisis with loyalists running the central bank and repeated mantra around how falling interest rates support growth and employment.
In addition, political stakes are much higher ahead of centenary elections due by 2023. Erdoğan and his Justice and Development Party are trailing in polling, so any public admission of failure on the economy such as vis-à-vis a rates reversal is likely seen by Erdoğan as damaging to credibility.
We have already observed that the government is pursuing a “de-globalisation” strategy in using forex reserves to intervene in exchange-rate markets – after having previously committed not to do so – and adopting specific forms of capital controls in discouraging depositing in foreign currency and selling of lira, to allow for lower rates while slowing down currency loss. The catch is that defending lira via such a strategy is unsustainable in the long run.
The policy is expensive, and only buys time. Turkey racked up foreign-exchange reserve losses of over USD 100bn over 2018-20. Net reserves ex-swaps, standing at negative USD 42.3bn as of October, represent a lasting testament to consequences of this policy framework, which would be risky to attempt again with the domestic sector losing confidence in value of lira, precipitating further capital outflow.
Instead of helping Erdoğan’s political cause, a lower interest rate policy in engineering higher economic growth appears to be this cycle damaging the likelihood of Erdoğan’s re-election. The weak currency is exacerbating high inflation and loss of purchasing power, especially among poorer households – central causes of popular discontent. Moreover, rate cuts are resulting in much higher long-end rates, tightening monetary conditions and exacerbating economic instability.
Should Erdoğan not alter course and electoral defeat were to appear inevitable, political tensions are likely to grow over 2022 and 2023 if the president turns to less democratic routes to hold to power. Risk of political crisis, in addition to economic and lira crises, represents a significant vulnerability with bearing on B/Negative Outlook foreign-currency credit ratings assigned to Turkey.
For more on Scope's forecasts for the global economy next year, please see: Scope Ratings' 2022 Sovereign Outlook.