A Reignited Crisis: Devaluation and Capital Flight

Once a shining beacon for emerging markets, the Turkish economy has continued its stumble, hitting record lows on currency valuation in late October 2020. Turkey’s economic footing prior to the beginning of the year was already on shaky ground, but with the outbreak of the coronavirus pandemic, the economy has slid into a gradual free fall. The country’s inflation was at a chronically high 11.9% in October, it lost nearly 30% of its currency’s value against the U.S. dollar this year alone, and unemployment was estimated to be at 14.3% during the second quarter.

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This is hardly an isolated event. In fact, the Turkish lira has been gradually losing value against the dollar since 2005, culminating in the Turkish currency devaluation and debt crisis of 2018. With a combination of austerity measures and a short-term hike in interest rates, a newfound, albeit fragile, stability was created based on high inflation rates. This fragility was unable to withstand the brunt force of the coronavirus pandemic, which led to a 10% contraction in the second quarter. The 15.4 billion dollar stimulus plan introduced by the government (valued at around 2% of GDP) provided limited support to the country’s most vulnerable.

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Although the government’s stimulus and policies have allowed key exporting sectors to function normally amidst the pandemic, ultimately, the stimulus was not enough to help the ailing economy stabilize. The situation was made worse by the fact that the government has consistently maintained sizeable current account deficits since 2000 with exceptions in 2001 and 2019. This alarming trend has continued into 2020, with the deficit increasing over 190% in September compared to the same month last year. These deficits have burdened state finances, heavily pressuring the lira, and leading to Moody’s warning earlier this year, that the country has “almost depleted the buffers that would allow it to stave off a potential balance-of-payments crisis.” Turkey’s hard currency reserves dropped to an estimated $36.3 billion in September 2020 compared to $143 billion in September of last year.

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The country has spent over $134 billion dollars within the last 18 months, and around $65 billion this year alone to support its currency. A currency swap with Qatar in May provided only temporary relief from devaluation, which in March and April alone was 10%. This coupled with a non-effective monetary policy has led to one of the biggest capital flights of an emerging market since the start of the COVID-19 pandemic. It is estimated that about $7.6 billion of foreign capital left the local currency bond market, and another $5.7 billion left Turkish stocks. This has compounded the negative effects of the crisis. That is to say, the losses in purchasing power, devaluation of assets, and reduction of government revenues and economic output are more severe.

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As it stands, the Turkish economy is crippled, and policymaking has become a minefield. The pandemic has only worsened the country’s stagflation. Globally, central banks are pumping large sums of money into the economy and lowering key interest rates, in some cases into negative territory. The Turkish central bank cannot afford to drop its rates for fear of increasing inflation, and it cannot increase rates for fear of crippling an already bleeding economy. In the short term, policymakers should aim to stabilize the effects of the pandemic, and stem losses, particularly of small and medium enterprises, which make up over 90% of all enterprises, employ 78% of the workforce and contribute over half of Turkey’s GDP. In the medium term, once global economic activity resumes pre-pandemic levels, the central bank should adopt drastic measures and maintain high interest rates until inflation is corrected. The economy will invariably enter a deep recession and unemployment will spike, but it will recover and those jobs will return once the market has readjusted.

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The Turkish Central Bank, however, has so far been relatively unresponsive to traditional indicators used to influence monetary policy, which has led to spikes in inflation and unemployment. In Turkey’s situation, it is more pertinent to understand the geopolitical landscape as it has had a considerable impact on this lapse in economic decision-making. Locally, the country has been mired in political instability, with elections being held annually since 2014 with an exception for 2016 where a coup attempt led to a two-year state of emergency and gradual political consolidation. Regionally, Turkey has been both directly and indirectly involved in regional armed conflicts. In addition, President Recep Tayyip Erdogan has employed a strong-arm foreign policy that has alienated Turkey’s traditional allies in the European Union and the United States that have gone so far as to suggest economic sanctions over its destabilizing effects in the region.

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Somewhere, mired into all of this, is the waning independence and influence of the central bank on economic policymaking. Erdogan has long held the unconventional belief that higher interest rates lead to higher inflation, as such, the bank, under this direction, has maintained this unconventional policy and it has so far been ineffective. It also stands to reason that implementing drastic measures to readjust the economy will likely come at a cost that Turkey’s Justice and Development Party – which has maintained control since 2002 – is unwilling to take. There is no easy way out for Turkey. Short-term band-aid fixes only add to socioeconomic and geopolitical instability, but might be necessary given the present extenuating circumstances. However, it is imperative that policymakers look at long-term stability and sustainable growth as a goal in implementing policies, even if that means short-term hardship.

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18 November 2020

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* Rashed Albinali is Member of the Economic Society of Bahrain.

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