Turkish Lira between Dollarisation and Sterilisation

The Turkish lira has lost 30% value against the dollar to a record low of 14.60 this year. Inflation in Turkey stands at 60%, the highest level in emerging markets. The central bank has slashed the interest rate to 14% from 24% over the last six months to provide unlimited liquidity via the money market. The central bank has continuously slashed interest rates below the inflation rate and depleted its net foreign exchange reserves in the lira’s defence, exposing it further. The interest rate of 9% is negative in real terms; the lira provides negative returns to investors and deposit holders, shaking confidence further and chasing the people in Turkey to dollarise their assets.

The Central Bank of Turkey (CBRT) resorted to the non-sterilisation of currency measures to stem the decline in the lira. It raised forex-lira swap market transaction limits to 30% of forex market transactions from 20%. The measure could help it raise an extra six billion dollars in reserves. Turkey’s banking watchdog, the Banking Regulation and Supervision Agency of the Guarantor (BDDK), bars foreign banks from carrying out dollar-lira forex transactions; after, some foreign finance entities bought large sums of forex and defaulted on lira liabilities to weaken it further. It also slashed the limits for banks’ forex swap, forward & derivatives transactions with non-residents and foreign firms. The measure could help in the withdrawal of lira liquidity from the offshore swap market, where traders regularly placed bets on the lira’s decline, causing the investors to flee.

The CBRT also stopped REPO and DEPO transactions with banks to stop the lira depreciation further. Turkey is curbing not to print more and more increasingly cheap lira. According to some forex traders, Turkey will need an International Monetary Fund (IMF) credit package at some point; the policy reforms attached to (IMF) funds have been disastrous for Turkey, like in Egypt in the past. Turkey has been made to repeat IMF borrower with 20 programs, the last of which ended in 2008.

The Making of Crisis

Turkey’s free-market reforms dictated by the IMF and World Bank introduced the full convertibility of the Turkish lira and the capital account in the 1990s. At the onset of the 21st century, vulnerability to external shocks for the Turkish lira and the economy was the factor since excessive short-term capital increased the ratio of short term foreign debt to forex reserves. The consequent build-up of external debt eventually gave rise to expectations of sharp currency depreciation. A rapid exit of capital and instability of chronic inflation rate raised the risk of assets denominated in Turkish lira, raising the interest spread that gave rise to safer dollar assets and facilitated currency substitutions to dollarisation & euroisation.

The short term foreign debt that had increased inflation was seen as the main reason for the actual depreciation of the Turkish lira, which caused high-interest rates, low private and public investment and low economic growth rates. The crawling peg forex rate regime had been replaced by a regime of free-floating forex rates on advice of the IMF. Abandoning the crawling peg and moving to free-floating under full lira and capital account convertibility led to extensive dollarisation that aggravated the crisis, resulting in the currency’s collapse. Public and private cash flow and liquidity were squeezed from rising external and domestic debt service obligations due to the collapse of the currency and the hike in interest rate.

As soon as capital control elimination came into force in the later period of the 1990s, the banks were allowed to execute the transaction in hard currencies, open forex deposits accounts and lend corporate forex credits, which paved the way for the privatisation of forex rate risk. This increased the banking sector’s weakness as the banks went to borrow more in the forex market; since unstable economic conditions increased the credit risk for banks, they went to finance the public deficit and invested in government bonds and treasury bills, which increased their open position in future and forward forex contracts.

The collapse in currency triggered the default in lira liabilities, as the margins call were not being honoured on forex derivatives contracts resulting in default on delivery of forex forward contracts, eroding in banks’ equity and assets quality. The lira crisis primarily resulted from the free-market reforms implemented in haste rather than a gradual and pragmatic approach that may have phased reforms. Due to the problems in the design and reform policies, stand-by credit package and supplemental reserve facility, IMF failed to deliver on its promises, plunging the lira into an unprecedented crisis, which proved much deeper in recent times.

Way Ahead to Stabilise Lira 

The damage associated with IMF bailouts is to be undone with heavy capital control; that is, the country must grab the capital flight, Turkey must bring in reforms in the capital market to access dollar liquidity, even if the U.S has been going squared to choke the dollar liquidity to Turkish system. According to Keynes’s method, no measures can be successfully applied when the capital account is open, the currency is fully convertible, and a temporary suspension of convertibility and standstills on an external debt can be considered.

Further, restrictions could also be needed on the capital account transactions of residents and non-residents. Significant fiscal and monetary tightening is required to shrink the current account deficit. To limit lira’s supply offshore, the BDDK should put stricter limits on banks to curb short-selling of the lira and forex transactions. Turkey should also take sterilisation measures to lift the lira’s supply off the market by trading in local currency with its trading countries. Qatar extended a 15 billion dollars currency swap back in time, and Japan and Germany are also reportedly considering providing forex credit to Turkey. The free market principle of IMF credit bailouts is a hard rationale to reconcile since market discipline regulates the price system and risk in markets.

Hashmat Ali is a PhD scholar in Finance.