7 Factors Lead to Emerging Market’s Currency Crisis — What I learned from Turkish’s Plummeting Lira

To watch the article in a full animated video, please visit my YouTube Channel: https://bit.ly/2mwZuex #HungryForGrowth

Turkish lira has hit a record low by August this year. In this article, we’ll discuss about the 7 key factors that drive a country’s currency crisis. And we’ll use Turkish Lira as an example.

Although Lira is depreciating, Turkey’s president, Recep Tayyip Erdogan, continues to cut interest rates and gives priority to economic development. Meanwhile investors are increasingly worried about the country’s current double-digit inflation. Ahead of next year’s elections, Erdogan calls himself an “interest rate enemy” and wants to keep borrowing costs low in order to continue stimulating economic growth through infrastructure projects. In the local media, Erdogan also often claims that the sell-off of the Turkish lira is an economic attack on Turkey by external forces.

Picture Source:Warriortradingnews

Pressure from Erdogan has led investors to worry that Turkey’s central bank is unable to control inflation. In July, Erdogan assumed the exclusive power to appoint the central bank’s board and named his son-in-law as the new finance minister. Moreover, in recent months, Turkey has firmly refused to give into United States’ demands to release the American pastor Brunson.

As a result, the diplomatic relationship between the two countries has deteriorated even further and, in early August, the United States Treasury announced limited economic sanctions against Turkey. In a tit-for-tat response, the Turkish side announced similar retaliatory measures. Turkey’s intention to buy Russia’s S-400 air defense system has also caused a great deal of dissatisfaction in the United States government, which eventually stopped selling F-35 aircraft to Turkey. On August 10th, the US government upgraded tariffs on steel and aluminum in Turkey, adjusting them to 20% and 50% respectively. These actions sent the Turkish lira tumbling to the biggest drop since the country’s banking crisis first began.

Picture Source: Radio.gov.pk

In fact, over the last few years, recent forecasts based on historical data all show that the collapse of lira was just a matter of time. It is fair to say that the collapse of the Turkish lira is being helped along by many external factors, such as geopolitics and world economics, but those events and trends have only been exacerbated by the recent political and economic decisions of Erdogan.

Let’s see how economic factors and political decisions can affect a country’s currency and possibly result in an economic crisis.

Vulnerable domestic economic conditions in emerging markets, a lack of international trade transactions and internally unregulated foreign exchange systems are the root causes of a currency crisis. These factors can lead to a point at which neither a country’s international investors nor its own citizens believe in the ability of the central bank to maintain monetary stability. This may lead to a situation so unstable as to ultimately result in a government’s decision to devalue the currency.

Picture Source:Middle East Eye

There are many indicators that determine a country’s currency crisis. The most used seven key indicators are: the real exchange rate, foreign exchange reserves, GDP growth rate, the current account balance, credit growth rate, inflation, and fiscal surplus (if any). Continued deterioration in any of these indicators can lead to economic imbalances and, unless swiftly remedied, can result in a significant devaluation of the currency.

1. Low real exchange rate. The real exchange rate is the rate obtained after the nominal exchange rate has been adjusted by the relative price index. It is adjusted according to the nominal exchange rate of the foreign and domestic price indices and is used to reflect the effect of the changes in the relative purchasing power of any two countries’ currencies. The impact of real exchange rate changes ultimately determines the international competitiveness of the two currencies. The real exchange rate and nominal exchange rate are normally more relevant, but in the event of a large difference between the domestic and foreign inflation rates, this might not be the case. For instance, Turkey has climbed from a 10% inflation rate since December 2016 to close to 16% in August 2018. This long period of high inflation has led to a large drop in Turkey’s real exchange rate.

2. High fiscal deficit. For emerging markets such as Turkey, the overly rapid development of domestic capital markets has led to a lack of capital accumulation and a resulting lack of capacity to finance investment demand. These domestic markets often turn to international financial markets to fill the funding gap, a borrowing mechanism which, in Turkey’s case, has led to long-term fiscal deficits.

In order to meet this demand, the country must either keep printing money to increase the money supply, resulting in demand inflation, where too much money is chasing too few goods, or continue to borrow from abroad, thus increasing the total amount of foreign debt. Whether the M2 growth rate (defined essentially as cash and short-term savings instruments) is too fast or the debt level is too high, the results are the same. Either is an unsustainable means of development and will ultimately reduce the credibility of the government and a devaluation of the national currency. Raising foreign debt begins to cost more and more as investor confidence wanes, while cash and any savings are worth less and the cost of foreign debt repayment increases relative to the nominal value of the domestic currency.

3. Low foreign currency reserves. Foreign exchange reserves are the first line of defense against a currency crisis, and to a large extent, determine the confidence level of a country’s residents in their own currency. Turkey’s foreign exchange reserves as a percent of GDP are relatively stable, fluctuating at around 10%, but still sitting among the lower tier countries. At the same time, Turkey’s economy is overly dependent on external demand. This creates a serious economic structural imbalance, with foreign trade accounting for 46% of Turkey’s GDP in 2017. Moreover, Turkey has run a severe trade and capital deficit over several years, which means that the country is now heavily dependent upon external investment and financing to sustain itself. Meanwhile, those relatively low foreign exchange reserves make it difficult for Turkey to withstand any currency crisis on its own.

Picture Source:123RF

4. Slow economic growth. Slow economic growth will also lead to a decline of a country’s overall ability to weather any external crisis. In the long run, the difference in nominal GDP growth rates between any two countries determines the relative appreciation or depreciation of their currencies, an economic reality which normally applies to most currencies. Turkey, as an emerging market country seeking high internal investment growth rates, has seen GDP growth of more than 10% over the past few years. Now this has fallen to below 4%. As the resulting gap between GDP growth in Turkey and the world economies financing Turkey (principally Europe and the US) has widened, the lira has often been depreciated, in an effort to resolve the evolving disparities.

5. High deficit in the current account. The measure of the current account is the most important item in the balance of payments calculation. It is regarded as a more accurate measurement of money flow. Due to the shortcomings of its industrial structure, Turkey’s domestic manufacturing industry is failing to meet demand and thus Turkey needs to import a large volume of manufactured goods. As a result, the current account deficit has remained high, reaching a 5.9 billion USD deficit in May 2018.

6. Overly rapid credit growth. Credit has an important impact on the economic development of a country: an arbitrarily low credit growth rate is not conducive to GDP growth, while too high a rate can lead to a risk of economic derailment. The high returns from rapid economic growth in emerging markets often result in asset prices being driven unnaturally higher by the influx of capital from competing international lending institutions. Turkey’s credit growth rate has remained at around 20% for a long time, and when Turkey’s GDP was growing by as much as 7% annually, this rate was manageable. But now that GDP growth has slowed to less than 4%, Turkey’s ability to repay its loans is now a source of concern, and this is putting pressure on any ability of the currency to stabilize.

7. High inflation. Inflation happens when a central bank prints more money than its country can produce goods to meet the resulting demand. Local products become more expensive in both the domestic and international markets and thus less competitive compared to foreign products. Consumers and businesses will normally choose to buy the same goods at lower prices from foreign competitors.

Picture Source: Fixing the Economics

Turkish inflation, which has also been on the upswing since the financial crisis of 2008, has recently exceeded 16%, which has had a big impact on the nominal value of the Turkish lira. Erdogan has resorted to blaming this rise in inflation and reduction in living standards as being the actions of external agents trying to destabilize the local economy and his government is urging Turks to buy local products and to trade their foreign currency savings for lira as a statement of national pride.

As mentioned earlier, currency systems are very complex, influenced by economic and many other domestic and international factors. These seven factors are just the most commonly used measures of currency value and stability, a lack of which can lead to a currency crisis. Through their measurements and resulting forecasts, we can develop a basic picture of the currency risks each country faces. Given Turkey’s recent political and economic decisions and ongoing diplomatic disputes with the United States, the Turkish lira’s collapse is not really a surprise. In fact, not just the Turkish lira, but the Hong Kong dollar, and the Argentine peso have had similar problems in recent years.

Because of the lower recognition and trust of these emerging market currencies, fewer investors are willing to accept them as investment grade currencies. It is thus difficult for emerging market countries to establish a sound hedge market against foreign exchange risk. In the face of a strong dollar, many emerging markets around the world will face a similar debt crisis. Moreover, a debt crisis is often followed by a currency crisis. With large amounts of dollar debt due over the next few years, many countries are facing a tough debt repayment schedule. Many may not pass the test and could thus face a currency crisis which would inevitably affect their trading and investment partners.

So, is this crisis really going to happen, as some economists are predicting? What are the potential costs for the world’s economies? If it does happen, are there any viable means to prevent or reduce widespread damage? We’ll discuss these questions in the next article.

I hope you enjoy this article. I also appreciate you clap and subscribe. Please comment below for any comments or feedback. Thank you.