This is the Turkish Lira. And, compared to the U.S. Dollar, it was basically on fire for most of 2022. But, as you can see in this chart, it was already falling relentlessly for a long time, and then started falling even faster in 2022. It was at this point that many news sources would start reporting like this.
<clip 1 will continue to drop interest rates even though global central bankers are communicating the opposite>
<clip 2 overturn central bank head. slashed rates>
<clip 3 stubbornly opposes >
But, to that Erdogan usually responded with something like this
So, while the Lira kept crashing, rather than increasing the interest rate, Erdogan’s government just kept lowering interest rates, from 18% in mid 2021, all the way down to 10.5% in October 2022.
And then, the Turkish Lira actually stabilized.
However, just before the Lira stabilized, other strange things started to happen. While Erdogan was for the longest time one of Israël’s biggest critics, saying stuff like this
Now they are re-opening their embassy in Tel Aviv. And, while Turkey’s government used to condemn the United Arab Emirates for allegedly funding a coup against them in 2016. Now, Erdogan seems keen to talk about friendship and brotherhood with them again. Finally, just after the Lira stabilized, at the World Cup in Qatar, mr. Erdogan for the first time shook hands with el-Sissi, a man whom he did not even recognize as the legitimate president of Egypt and had previously referred to as a “murderer”.
So, what happened? Did Turkey actually save its economy by lowering interest rates, or did Erdogan see no other way out of the crisis than to basically sell his country’s economy to his former enemies?
Well, to answer that question, we first need to investigate the following:
Why was the Lira Collapsing in the first place?
To answer questions about international finance, I always like to go back to good old supply and demand. According to economic theory, there are two main reasons for people to supply or demand a currency: the first is for financial gain and the second is trade.
Let’s talk about financial gain first with an example. Let’s say that one country randomly starts increasing its interest rates, while others do not. This will make that countries currency more attractive, compared to other currencies, increasing the demand for it, and thus increasing its price. This could explain why the Dollar has been so strong compared to most other currencies. After all, the Fed started raising interest rates more quickly and aggressively than most other central banks. And, if we apply this concept to Turkey, it implies that the reason it’s currency kept collapsing was that it’s interest rates were simply too low.
Indeed, this is why most economists were telling Erdogan to raise interest rates.
However, the problem with this explanation is that, in the past, Turkey actually had really high interest rates for a long time and their currency was still falling.
Some economists even argue that it were precisely these high interest rates that made the Lira so weak. You see, having high interest rates made borrowing in Lira really unattractive. This meant that more and more Turks started borrowing in foreign currencies with low interest rates such as Dollars and Euro’s. Listening to economic wisdom, the Turks recognized that this was potentially really dangerous. After all, if most of its citizens were borrowing in Dollars, and the Lira dropped, this would drastically increase their debts.
For example, say that Turkish companies had borrowed 1 Billion US Dollars when they were worth 1 Billion Liras. This seemed like a good idea at the time since Dollar loans required a much lower interest rate than Lira loans. However, if the Lira then loses half of its value. This means that the debt of Turkish companies is now twice as much, in Lira terms. Now, this could potentially mean that Turkish companies will go out of business because they cannot repay their debt..
So, what the Turkish government did in response was to Dollarize its economy. In practice, this means that it made it easier for citizens to open foreign currency bank accounts. This allowed many Turks hold dollars at their local banks.
To see how this might help, let’s go back to our previous example in a Dollarized economy. Let’s say that Turkish companies also held most of their savings in Dollar accounts at their local banks. If the Turkish Lira now halves in value, it would still mean that the debt of Turkish companies will be twice as difficult to repay. However, because most company savings were now also in Dollars, the Lira value of their savings also doubled. As you can see, this means that Turkish companies see the Lira value of their debts increase. But, also their savings. Meaning that far fewer companies are likely to get into trouble.
However, on a macro level, this strategy produced an unwanted side effect.
You see, every time the Lira would go down in value, Turks had easy access to a bank account with foreign currency. This allowed them to quickly sell Liras for Dollars to protect their savings. Ironically, this would then actually make the Lira fall further. Of course, this made the currency much more unstable and, given that one function of money is to be a stable store of value, it also made the Lira much less attractive, and therefore depreciate.
In response, the Turkish government introduced its so-called ‘Lira-ization’ strategy around the end of 2021. This strategy included making foreign currency accounts less attractive for Turkish banks to offer foreign currency deposits and, simultaneously, making Lira deposits more attractive to Turks by protecting them from wild currency swings.
And while adoption was slow at first, these protected Lira deposits were actually wildly popular already around November this year. And, so, this could actually have really helped to stabilize the Lira.
However, at the same time, Turkey saw the return of it’s
Massive Trade Problem
This problem is related to the second key factor that drives the rise and fall of currencies: trade.
As you can see here, Turkey historically imported way more than it exported. And, while Turkey’s trade deficit was finally improving before 2020, it got way worse during Covid, when all tourists were shut out of the country. And then, crucially at the start of 2022, energy prices shot up after Ukraine was invaded. And, as you can see in this graph, this made Turkey’s trade deficit much worse.
So, from this perspective it is not surprising that the Lira just kept falling throughout 2022. After all, on average, Lira’s needed to be sold on the foreign exchange market to pay for these imports. After all, gas and oil needs to be paid for in Dollars. So, when these prices skyrocketed, more and more Turkish Lira’s were offered on the foreign exchange markets just so that Turks could literally keep the lights on.
This meant that while Erdogan’s protected bank account scheme was helping on the financial side, it likely wasn’t enough to completely stabilize of the Lira. And, so, Turkish voters were getting really really unhappy with the tumbling Lira, and the resulting sky high inflation.
Hoping to be re-elected in June next year, Erdogan simply had to do something.
But, he couldn’t immediately increase Turkey’s exports, or reduce its reliance on energy imports. So, his solution had to be financial. And, since he had already done his best convincing Turks to hold Lira, it seemed like he had no other option than to raise interest rate to convince foreign investors to buy Lira’s.
Orrrr, he could come up with yet another
Highly Unorthodox Solution
And yeah, in some cases, this required a bit of a political acrobatics from mr. Erdogan.
So, sure Erdogan said the following about Israel in 2014
<clip a terrorist state>
But, now diplomatic relations are restored and Israel might start helping Turkey to become energy independent, reducing it’s trade deficit.
What’s more, while it was delivering drones to Ukraine, and while its NATO allies were greatly reducing their exports to Russia, Turkey’s trade with Russia exploded. Oh, and, what’s also nice is that they got a 9.1 Bn loan from Russia to build a Nuclear power plant.
And, while it wasn’t a huge surprise that it secured a 10bn loan from its long standing ally Qatar, it was a big surprise that Erdogan would also get a 5bn Dollar investment from Qatar’s rival Saudi Arabia. Finally, the United Arab Emirates, which allegedly funded the 2013 attempt to overthrow Erdogan, are now also back in Turkey’s good graces, after signing a 4.9 billion currency swap deal.
So, yeah, these are the two unorthodox strategies mr. Erdogan employed to save the Turkish Lira. First, he started the process of Lirarization and second, while he said
he was at the same time asking his former rivals to get the Dollars he needed to prop up the Lira, without needing to raise interest rates.
But, yeah, it seemed to have worked, at least for now. It buys the country time to reduce its energy dependence. And, if it is actually able to do that, it might even reduce its dependence on former rivals again.
However, that is pretty optimistic, because, as one of Turkey’s most famous economists has noted:
Turkey has a serious productivity problem because its government has compromised the independence of key institutions and failed to encourage the development of new thought and technologies.
And, if it fails to develop a sustainable economy, borrowing from it’s rivals might come to haunt it. After all, Lebanon’s rulers had tried the same strategy of borrowing from rivalling Middle Eastern states, and their economy collapsed in part because it’s previous backer Saudi Arabia wasn’t happy with its politics.
So, what do you think. Was this a smart move by Erdogan, or did he basically sell his country to buy votes for the upcoming election? Let me know in the comments.