Research On Economic Crisis In Turkey In 2018

Executive Summary

Prior to 2018, Turkey’s economy was the 17th largest globally, by GDP, valued at $910bn. The emerging market is now facing a significant threat to this position. The value of the Turkish Lira has plunged by approximately 40% since early 2018. During this period, Turkey has entered into a serious and debilitating economic crisis; resulting in significant record inflation increases, currency devaluation and an increasing proportion and value of debt defaults (both domestic and international). Turkey’s economic decline has been long-coming, stemming from an ongoing rising in current account deficits, risky levels of foreign-currency debt, an over-reliant economy on foreign investment, and political instability and influence on fiscal policy. As Turkey’s financial position continues to worsen, the impact on the global economy, and fears of ‘contagion’ grow. Depreciation of the lira has also seen other emerging currencies including the Argentinian peso and South African Rand decline.

Part I. 2018 economic crisis in Turkey

Turkey’s emerging economy presented as a very attractive proposition to global investors because of its high economic growth and relative resilience through the 2008 global financial crisis. Growing investments and a boom in the construction industry rapidly boosted Turkey’s GDP which grew 3-fold since 2000. However, 2018 brought economic decline with a significant currency and debt crisis.

The rapid and drastic devaluing of the Turkish Lira

The Turkish Lira has declined by approximately 40% in value against USD since early 2018, with aggressive losses seen since August 2018. The lira fell to a rate of 6. 88 against USD in mid-August, compared with a rate of 3. 79 at the beginning of this year. High inflation and the geopolitical climate are exacerbating the currency crisis.

Rising inflation

The credit boom and declining currency value have severely impacted inflation, reaching ~25% in September 2018, with average prices increasing 6. 3 percent since August - demonstrating flailing consumer and investor confidence in the market. The rising inflation is driven primarily by increasing transportation and food prices, with anticipated further increases to come.

Debt Crisis

Heavily reliant on foreign loans, Turkey’s gross debt is valued at nearly $450billion USD and the lira depreciation further perpetuates this debt crisis. The value of debt has risen dramatically to nearly 80% of GDP, compared with 44% in 2017 given the debt is largely financed in foreign currency. Turkey’s inability to repay this debt further devalues the lira and we see a vicious cycle of loan default and currency devaluation. Investor confidence in the economy, or lack thereof, is sure to prevent refinancing of loans at the maturity date, forcing corporations to repay loans significantly impacting liquidity in the market.

Part II: What caused the crisis?

The Global Financial Crisis and its impact on Turkey

Turkey’s macroeconomic policy leading up to and during the global financial crisis allowed it to navigate well through the crisis. This policy focused on reducing budget deficits and minimizing debt. The central bank was granted independence and an explicit inflation targeted framework was introduced. These reforms were instrumental for disinflation. The banking sector was also restructured and banking supervision enhanced. These reforms along with a stable political environment reduced investment risk, minimized capital costs, and boosted financial activity within the Turkish market. In addition, Turkey also strengthened its relationship with the European Union which also had a positive impact on investor confidence. The global financial crisis of 2008-09 had a tangential impact on the Turkish Economy. While reducing foreign demand led to a collapse in exports and subsequently GDP, the impact on the domestic financial structure was fairly minimal. The rapid and sizable deterioration in economic growth triggered a prompt monetary and fiscal policy response. These monetary policy measures were key to pacifying the markets in the crisis and was appreciated by the domestic market. The Central Bank cut the interest rate and to support liquidity and lending, the Turkish Lira required reserve ratio was cut by 1%. The government implemented an anti-crisis package based on both spending (investment in infrastructure projects, reductions in contributions to the pension and health care funds, and freezing hikes in public servants’ salaries) and revenue measures (temporary cuts in special consumption and value-added taxes on selected goods) which navigated the Turkish economy into recovery. Following a historical reliance on the International Monetary Fund (IMF) for financial assistance, Turkey distanced itself from the IMF in 2009, declaring it would manage its debt challenges without IMF support. The Turkish economy survived the global financial crisis without the need for formal financial support however the crisis impacted export revenues, largely due to demand declines from EU importers. Turkey has since, not adapted its strategy through the post-crisis financial environment, expecting the above policies will continue to boost its economy. There exists a lack of understanding on the global impact of the financial crisis and their impact on the Turkish economy and this has led Turkey into the 2018 currency and debt crisis. With an unfavorable investment climate across the more developed economies, global investors looked at rapidly recovering Turkish economy as an attractive proposition. This led to a period of credit-fueled growth with a focus on the construction industry, the state awarded contracts and stimulus measures. Turkey’s financial crisis is largely attributable to a convoluted monetary policy and chaotic political policies following the global financial crisis, which has allowed it to amass excessive and growing current account deficits and significant levels of foreign currency debt.

Current Account Deficit and Lira Depreciation

Turkey presented itself as an attractive destination for international investors, since the global financial crisis, with 6. 9% annual average growth compared to 3. 8% globally. This period though was characterized by heavy borrowing by Turkish Banks and large firms from foreign investors, typically in US Dollars, which supported Turkey’s large annual current account deficits averaging 5. 5% of GDP. Turkey now holds one of the largest current-account deficits globally, valued at $51. 6billion in 2018. This deficit has been steadily increasing since the global financial crisis. Given the value of its imports so greatly exceeds its exports, the economy is highly susceptible to external shocks and relies heavily on the inflow of external sources of capital. Banks and large corporations in Turkey continues to hold debt, often in USD, and Turkey’s meager currency reserves ~$85bn (circa 10% of GDP) are hardly adequate to fund its debt and current account deficit by directly attempting to influence the lira in foreign markets (i. e. selling foreign currency in exchange for lira to increase the demand for lira). Turkey is thus heavily reliant on capital inflow from external sources to manage these debts. Turkey’s financing costs increased as the US Central Bank started increasing interest rates. Additionally, investor perceptions of Turkey’s creditworthiness have been at risk because of the volatile political climate (2016 political coup, presidential interference in the central bank monetary policies, and political standoff with the Eurozone and the USA).

Political influence on the Central bank’s activity - President Erdogan’s government has interfered with the central bank over the past ten years and prevented interest rate increases due to his concerns it discourages investment within Turkey and curbs economic growth.

Conflict with the US regarding trade policy - In August 2018, President Trump doubled tariffs on Turkish metals. In retaliation, and to the detriment of the US-Turkish relationship; the Turkish government raised tariffs on US imported goods, specifically alcohol, cars, and cigarettes, even tripling the levies on cars which it raised to 120% from 35%. This has significantly impacted Turkish-US relations given it will so drastically increase the cost of US goods, and will further destabilize the lira.

Part III: Actions taken to support the Turkish economy

The Central Bank of Turkey (CBT) and government have moved to aid the economy and support recovery in the lira value through several measures. Despite these actions and support from its allies, Turkish inflation remains high at 24. 5% in September, with the USD valued at 6. 13 Lira as at 5th October 2018.

Liquidity and market stability management

Despite the political challenges it faces with the Erdogan government, the Turkish Central Bank has taken action to support the economy; decreasing the value which lenders must deposit with the regulator. The Banking Regulation and Supervision Agency have also placed a limit on lenders currency swap transactions, now at 25%, to limit access to Lira liquidity in the offshore swap market. The new regulations decrease the swapping of foreign exchange derivatives with overseas banks. The intention; to decrease short-selling of the currency, where the market saw External Funds borrowing lira from local lenders to bet against its value and short, (overnight dollar/Lira swap surged to 15-year highs, over 34%) which further devalued the lira. Indeed these measures are critical with reports UK Foreign Exchange firms are facing an incredibly high demand for the Turkish currency.

In an effort to stabilize the banking sector through the crisis, and minimize the daily fluctuations in security prices, the Central Bank has taken the rather unorthodox step of suspending the impact of mark-to-market calculations in capital adequacy ratio metrics. The banks must thus value assets according to their market value as opposed to their book values. The hope is to wait out the market volatility until security prices hold more steady and the fluctuations subside. Seeking external support: A bailout in the form of a $15billion investment in Turkey’s financial markets was announced by Qatar in August 2018 to support Turkey through its currency and debt crisis. This investment is anchored by a $3bn currency swap. This capital injection will aid Turkey to continue to avoid the IMF for financial support however in the long term, an IMF assistance is likely required. Support has also come from other global economies. Russia has agreed to settle bilateral trade agreements with lira instead of the usual process in US dollars, protecting Turkish companies from further exposure to the currency risk. China also signed a $3. 8 billion financing agreement with Turkey in late July.

Raising interest rates

In September 2018, the Turkish Central Bank announced its decision to raise its short-term interest rate from 17. 5% to 24% to address the currency crisis and to control inflation (see exhibit 3). This has been a necessary measure although unexpected due to Erdogan’s anti-interest fiscal policies and the Turkish lira began to recover shortly after the rate rise.

Part IV: The global impact of turkey’s crisis

Turkey is at a high risk of defaulting on outstanding debts, given the rapid growth of debt to nearly 80% of GDP. The lending markets must insure themselves against this risk. Turkey will likely need an IMF assistance package to weather the debt crisis, this is misaligned with Erdogan’s monetary and political policies. Having the same characteristics of high external debt as Turkey, other Emerging countries including Argentina and South Africa are facing the same issue- depreciation of the countries’ currencies. Followed by The Federal Reserve announcement on raising its benchmark interest rate by 25 basis points in March 2018, investors have started refocusing the US market, where they can once again earn a decent return. To prevent some of this money leaving their shores, emerging-market economies have no choice but to increase their own interest rates. The Argentine central bank raised the interest rate to 60% in August to prevent its currency from further declining. It has also requested the IMF to release funds of $50billion to ease the concerns that the country will default. South Africa recorded a 0. 7% drop in GDP in the second quarter of 2018, triggering a sell-off in Rand. The currency has dropped to its lowest level in 2 years.