Turkey’s Slow-Motion Economic Crisis
Banks cannot engineer a balance between exchange rates and interest rates in a country with free capital flows, where banks’ funding conditions are affected by the global economic environment and by country risk. As Turkey has demonstrated, using banks for this purpose destroys both internal and external economic balances.
ISTANBUL/WASHINGTON, DC – No one should be surprised by Turkey’s recent economic and financial woes. The country’s triple crisis (currency, banking, and sovereign debt) has been unfolding for years. Whether this economic turmoil will incite political turmoil is now a widely debated question.
Prolonged high inflation and widening deficits were stalking the Turkish economy even before the COVID-19 pandemic hit. For over a decade, inflation expectations have exceeded the 5% target by more than half. And the Turkish lira has been depreciating against the US dollar since late 2017, with a 20% decline in August 2018. Aggressive policy accommodation during the pandemic, an unsustainable policy mix that relied on excessive credit growth, and the sale of the central bank’s foreign-exchange (FX) reserves to offset the impact of capital outflows generated further vulnerabilities. This led to a further 40% loss in the lira’s value since last January.
In November, President Recep Tayyip Erdoğan appointed a new finance minister and central-bank governor. Subsequently, the country’s monetary-policy framework underwent a long-overdue normalization (with a cumulative rate hike of 675 basis points in two months), and the lira regained 10% of its lost value by the end of the year.