International

Explainer | What led to Turkey’s currency crisis?

The Turkish President is expected to continue pushing for lower interest rates as he prepares to fight elections next year.   | Photo Credit: Reuters

The story so far: Turkey’s official currency, the lira, has been in a free fall recently, losing about a quarter of its value against the U.S. dollar in November. Since the beginning of the year, the currency has lost almost half of its value. The lira has in fact been depreciating over an even longer time. It took two liras to buy a U.S. dollar in 2014. Today, it takes more than 13 liras to buy a U.S. dollar. Turkish President Recep Tayyip Erdogan’s unconventional economic policies have been blamed for the country’s currency crisis.

Why is the lira losing value so rapidly?

The value of any currency or any good for that matter depends on, among other factors, how scarce it is compared to other things. For example, if there is an unlimited supply of liras in the market but only a limited supply of food, each lira will buy you very little food. The same logic applies when we compare currencies. The supply of Turkish liras in the market has been rising rapidly when compared to relatively harder currencies like the U.S. dollar. According to World Bank data, Turkey’s broad money supply rose by about three and a half times between 2014 and 2020 while broad money supply in the U.S. rose by around 50% during the same period. Not surprisingly, this has caused the value of the Turkish lira to drop against the U.S. dollar.

The demand for a currency too can affect its value. Turkey has one of the largest current account deficits in the world, which means that the value of its imports is much larger than the value of its exports. The country has traditionally depended on foreign investment to fund the gap between imports and exports. But foreign investors who help fund the current account deficit generally want some degree of certainty about the exchange rate. This is because their business projections depend heavily on what the exchange rate will be in the future when they try to convert their money back to dollars. As the Turkish central bank becomes erratic in how it regulates the supply of liras, the exchange value of the lira has become increasingly unpredictable. So, foreign investors have become reluctant to purchase liras to invest in Turkey, which in turn has led to a drop in the demand for the currency.

What has caused the rapid rise in the supply of liras?

Mr. Erdogan’s unconventional monetary policy beliefs have been the main culprit behind the rising supply of the lira. The Turkish President has been a fan of low interest rates, which he thinks is crucial to boosting economic growth and bringing down inflation. It should be noted that the central bank influences interest rates by regulating the money supply. To lower interest rates, it flushes the loan market with fresh money so that the price of bonds and other forms of debt increases (thus pushing down their yield). This in turn causes the overall money supply and hence prices to rise.

Many economists do advocate the lowering of interest rates when they believe the economy is not operating at its full capacity. This is since they believe that prices are sticky downward and that the central bank can trick people into accepting lower real wages by devaluing the currency. But once an economy reaches its full capacity, economists argue, any further lowering of interest rates will only cause inflation. Mr. Erdogan, however, seems to believe that no amount of lowering of interest rates will cause prices to rise. In fact, he has argued that high interest rates are the reason prices in the economy rise as they add to costs. His regime also believes that low interest rates will bring down inflation by boosting growth which increases the supply of goods. So, according to Mr. Erdogan’s logic, a central bank can print unlimited amounts of currency and still avoid hyperinflation by sufficiently boosting growth.

Mr. Erdogan believes so much in the power of low interest rates that he has removed three central bank chiefs since 2019 because they tried to raise interest rates to boost the value of the lira. The current central bank chief has cut interest rates and has even gone on record to defend his decision to cut interest rates despite high inflation. Turkey’s official data suggest that the country’s inflation rate is at around 20% while unofficial estimates peg the inflation rate at 40%. This has led to serious doubts about the independence of the Turkish central bank and caused people to lose confidence in the lira.

Why does it matter?

The rising supply of liras matters for at least two reasons. One, the creation of fresh currency usually leads to significant redistribution of wealth among citizens. This is because the fresh currency that is created by the central bank generally gets distributed among citizens in an arbitrary manner. So, some people may end up with greater purchasing power than before while others are left worse off. Secondly, a currency that is rapidly losing value can debilitate economic activity. People have very little incentive to produce new stuff when they are unsure about the real value of the currency that they accept in exchange for what they produce. A lira might buy five loafs of bread today but only one loaf of bread tomorrow. This is why people tend to move towards accepting alternative currencies such as gold and silver which better maintain value or resort to some form of barter when high inflation has rendered the official currency worthless. Turkish citizens have been converting their liras into gold, the U.S. dollar, and other assets to prevent further erosion of their wealth. Many have also begun to flee the country.

What lies ahead?

The Turkish President is expected to continue pushing for lower interest rates as he prepares to fight elections next year. It is generally believed that low interest rates boost the economy and make voters happy, although some economists do raise concerns about the sustainability of such artificial debt-fuelled growth. Lower interest rates are likely to lead to a further rise in the supply of liras in the market and cause a further drop in the currency’s value. Many hope that Mr. Erdogan might have second thoughts on lowering interest rates as the lira continues to lose value rapidly, but that seems unlikely.

prashanthperumal.j@thehindu.co.in


Our code of editorial values

Related Topics
This article is closed for comments.
Please Email the Editor

Printable version | Jan 18, 2022 3:48:39 PM | https://www.thehindu.com/news/international/explainer-what-led-to-turkeys-currency-crisis/article37861129.ece

Next Story