Watching the immolation of Turkish Lira

Turkish Lira has been sacrificed in President Erdogan's quest to stay in power

Turkey is a deeply divided country. There’s a secular elite on the coasts and a very religious, conservative population in the interior. The way President Erdogan has stayed in power is by manipulating the banking system to produce one credit boom after another, lifting per capita GDP far above its emerging market (EM) peers. This policy is inherently destabilizing. Credit booms boost consumption, which sucks in imports and widens the current account deficit to unsustainable levels. Repeated currency crises have been the inevitable result, making Turkish Lira the weakest currency across all of EM in real effective terms.

All this came to a head during COVID. Erdogan unleashed what at the time was an unprecedented credit boom to keep the economy going during the pandemic. That sharply widened the current account deficit, causing Turkish Lira to depreciate. In November 2020, Erdogan appointed a hawk to run the central bank (Naci Ağbal) who hiked interest rates and successfully stabilized the currency. Ağbal was fired in March 2021 and - as the chart above shows - what followed were a series of rate cuts that sent the Lira into free fall. There’s two reason those rate cuts were so catastrophic. First, they removed any semblance of central bank independence. Second, the came amid rate hikes everywhere else, so rate rate differentials moved sharply against the Lira. The irony is that Turkey’s central bank was eventually forced to hike rates far higher than they ever would have been had Ağbal just been allowed to do his thing.

The chart above looks at real effective exchange rates across all advanced and emerging markets. The gray shaded area denotes the strongest and weakest real exchange rate across all countries. Turkey’s real exchange rate is in blue and is the weakest currency across the 34 countries I’m looking at here. The real exchange rate factors in Turkey’s high inflation rate relative to its trading partners. So the fact that the Lira is so weak is nothing short of remarkable and a terrible indictment of past policy mistakes and the continued reliance on credit stimulus to drive growth.

What are the lessons to be learned? Turkey’s basic problem is Erdogan and his desire to stay in power. As long as he’s around, the government’s main priority will be to lift growth as much as possible. That means there’s no end in sight for credit booms and thus no end to depreciation pressure on the Lira. The other lesson is that - in such an environment - central bank independence is an illusion. Truly restrictive monetary policy and the high interest rates it entails are incompatible with the kind of credit expansion Erdogan requires. Whatever anchor Turkish Lira once had has been lost.