Is this the Turkish Lira's Demise?

Ranging from changes in investors’ expectations to political intervention and monetary reform, the Turkish Lira’s 1999 to 2020 exchange rate 𝐸₺/€ manifests an astonishing breadth of economic history. By 1999, the Lira had already undergone periods of record inflation and a plethora of government-enforced exchange rate regimes. The result of a “crawling peg” regime (controlled, constant depreciation with narrow fluctuation) is still seen from 1999 to 2001. During this time, the Turkish central bank engaged in the buying and selling of domestic and foreign currency to keep the exchange rate ‘pegged’ within a narrow band, and thus had little control over monetary policy. In 2001, financial and political instability due to poor government debt management, combined with the central bank’s inability to react, led to an economic crisis [2001 Turkish e.]. The crawling peg collapsed and a “managed float” was adopted, meaning more volatility with little active intervention.

The above equations will help explain some foreign exchange mechanisms that follow. The “Spot” rate is derived from the so-called “uncovered interest parity”, which states that due to arbitrage, returns on Lira deposits accruing interest must be equal to returns on euro deposits. Thus, variables influencing the spot rate “𝐸₺/€” are the long run expected rate “𝐸₺/€𝑒” and interest rates (𝑖) in both countries. “LR”, the long run expected rate, shows 𝐸₺/€𝑒 will approach a level equal to the ratio of price levels “𝑃₺𝑃€⁄” of the countries over time. According to monetary theory, price levels are in turn functions of the money supplies (𝑀), interest rates (𝑖) and income levels (𝑌). “ROD” shows the rate of depreciation of the Lira; an approximation of the ‘rate of change’ of 𝐸₺/€ and is equal to the inflation differential (inflation = 𝜋 = 𝜇 - 𝑔).

From 2001 to 2016 the overall trend of the Turkish exchange rate against the euro shows gradual depreciation with some fluctuations. During this time, Turkey experienced rapid GDP growth (11% 2011[GDP]) mainly fueled by massive government spending, private debt (70% of GDP, 2016) and public debt (30% of GDP, 2016) [Koc]. Income levels failed to keep up, causing rapid inflation. Despite this, President Erdogan declared himself in favor of continued spending and low interest rates to drive more growth in 2017. This meant high 𝑀T and higher expected price levels, thus a higher 𝐸₺/€𝑒, low 𝑖₺ and a rising spot rate. The increased ROD was due to only moderate European inflation but massive money supply growth in Turkey. For investors, lowered interest and expected future depreciation meant decreasing domestic returns, causing them to flood the forex market, driving the rate up. The high 𝐸₺/€𝑒 also caused foreign returns to rise, raising the Euro’s relative value and thus 𝐸₺/€ even more. This mechanism is called “overshooting”. However, it is difficult to disentangle this effect from what happened simultaneously; growing uncertainty over the currency’s future due to a “coup d’état” attempt (2016), ongoing war in Syria and heavy U.S. sanctions and tariffs on Turkish exports amplified the effects. The result was a 30% plunge of the Lira’s value from 3.2₺/€ in 2016 to a peak of 7.4₺/€ in 09.2018 [ECB]. The central bank stepped in and drastically raised interest rates (towards 𝑖₺= 20%[Koc]) to attract investors again, who would then demand more Liras, thus increase its value and slow depreciation. Bonds were sold and the central bank guaranteed high future 𝑖₺(↓𝑀T, thus ↓𝐸₺/€𝑒, negative 𝜇𝑇 so ROD was briefly negative), moving 𝐸₺/€𝑒 back down and with it 𝐸₺/€ to a lower level around 6₺/€ in 2019 [ECB]. For the moment, the Lira’s depreciation has plateaued, but Turkey’s instability remains reflected in high volatility and worries in light of the recent corona pandemic threaten it once again.

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