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Does the collapse of the Turkish lira pose more than just a local threat?


Nathan McClelland

By

August 31st, 2018


The Turkish lira has had a rough start to 2018. Nathan McClelland explores the factors propelling its downward spiral, and whether the global economy could be affected.


In the off chance you had better things to do than track the performance of the Turkish lira, I shall provide you a quick update. Over the last few weeks, Turkey’s currency has collapsed more than 20% against the US dollar. Foreign investors have been pulling money out of the Turkish economy by selling the lira in exchange for other currencies (mostly USD). A rapid devaluing currency poses a great risk to a country’s economy through carry trades and foreign debt. At first glance, this economic crisis seems isolated within Turkey, however, the chain reactions they elicit can impact global markets.

Deteriorating relationship with the US

The immediate effects of the current Turkish crisis stemmed from US economic sanctions; more specifically, tariffs on aluminium and steel. Investors have seen first-hand the aftermath of ‘Trump tariffs’ on a country’s economy. China, an economic powerhouse, had its stock market rattled from crippling tariffs – which they are still suffering – pushing stock values down over 20% from their previous highs. One can only imagine the effects Trump’s tariffs may have on a less developed country like Turkey.

Source: https://twitter.com/realDonaldTrump

Increasing value of debt

In recent times, developed countries such as the United States, Japan and those from Europe have lent billions of dollars to developing countries like Turkey. This has resulted in Turkey racking up US$466 billion of foreign debt – surpassing levels accrued during the 2001 financial crisis, as depicted below. [1]

Source: https://www.businessinsider.com.au/turkey-lira-balance-of-payments-crisis-2018-8?r=US&IR=T

When a domestic currency drops by 20 percent relative to a foreign currency in a few weeks, it simultaneously means foreign currencies have relatively appreciated. In layman’s terms, a weaker lira means a stronger dollar, which results in increasing difficulty for Turkey to pay back their dollar-based debt.

To rub salt in the wound, Turkey’s president, Recep Tayyip Erdogan, has shared strong beliefs that high interest rates are the “mother of all evil”.[2] It seems Erdogan has no intentions of increasing interest rates to try and attract foreign money back into the economy. Carry trades may be the last solution to slam the brakes on the lira freefalling. Why would any investor want their money in a country where their president fails to show knowledge of basic interest rate theory? This point will be discussed in the next paragraph.

Capital outflow – carry trades

Many developed countries such as the United States, Australia and Japan have had very low interest rates for years, as they try to stimulate spending to return their economies to levels preceding the global financial crisis. With Turkey’s interest rates at 17.75%, it naturally acted as a magnet for carry trades.[3] A carry trade can be defined as a trading strategy that involves borrowing at a low interest rate to invest in a country with a higher interest rate – netting the profit from interest rate differentials.[4] However, from years of low interest rates, developed economies are seeing strength return to their economies in the form of economic expansion, job growth and inflation. In June,  the US Federal Reserve voted to raise interest rates to 1.75 – 2% – the highest level since 2008. The United States’ increasing interest rates over the past couple of years are graphed below. This has resulted in capital flows reversing out of Turkey back into the United States fuelling the Lira’s freefall.

Source: https://tradingeconomics.com/united-states/interest-rate

Can this crisis spread globally?

From past crises, we know that these events can cascade through the banking system. The foreign debt needs to come from somewhere, and the majority of it comes from foreign banks. Thus, as the dwindling lira forces companies, investors and governments to default on their debts, these loans directly impact the condition of financial systems in other countries. This is what investors are most concerned about today. Large European banks such as Italy’s UniCredit, Spain’s BBVA and France’s BNP Paribas are exposed to such risk.[5] If these larger banks cannot recoup their original loans, one must ask whether they have enough capital to pay back their own debts. As you can see, this perpetual process can amplify the scale of the crisis.

Furthermore, we mentioned previously; “developed countries … lent billions of dollars to developing countries such as Turkey”. That is, Turkey is only one example of an economy reliant on foreign lending. If cracks start appearing in other developing countries such as Argentina or South Africa, the global economy could witness a domino effect further deteriorating global wellbeing.

The lira has been one of the most unloved currencies in 2018 with its fate largely in the hands of Erdogan. Unless he can return confidence back into the currency, investors will remain cautious about the Turkish economy.

 

Picture source: https://pixabay.com/en/background-banknote-bucks-business-2622/

 

[1] Turkey Total Gross External Debt | 1989-2018. (2018). Retrieved from https://tradingeconomics.com/turkey/external-debt

[2] Kucukgocmen, A., & Taner, B. (2018). Turkey’s Erdogan calls interest rates. Retrieved from https://www.reuters.com/article/us-turkey-currency/turkeys-erdogan-calls-interest-rates-mother-of-all-evil-lira-slides-idUSKBN1IC1NV

[3] Turkey Interest Rate | 1990-2018. (2018). Retrieved from https://tradingeconomics.com/turkey/interest-rate

[4] Carry Trade. (2018). Retrieved from https://www.investopedia.com/terms/c/carry-trade.asp-0#ixzz5PYVoiN1v

[5] Koranyi, B. (2018). Euro zone banks hammered for Turkish exposure. Retrieved from https://www.reuters.com/article/us-turkey-currency-europe-banks/euro-zone-banks-hammered-for-turkish-exposure-idUSKBN1KV1P0

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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