After a whirlwind few days, Turkish financial markets appear to have returned to relative calm. Following speculation that the Central Bank of the Republic of Turkey (CBRT) had unexpectedly drawn down on foreign reserves (rumors that proved later to be unsubstantiated), the Turkish lira lost considerable ground against the U.S. dollar on Friday. This followed comments by Treasury and Finance Minister Berat Albayrak that those that were banking on a post-election devaluation would be disappointed as the lira would stay strong.
On Monday, the lira regained some of the ground it had lost Friday, and on Tuesday it actually appreciated against the dollar, returning to levels it had last seen in February. While it has returned some of those gains as of this writing on Wednesday, the currency is still stronger than it was before this mini-currency crisis. To be clear, we are talking about a depreciation of 6 percent followed by an appreciation of 9 percent in the course of three trading days for a total move of 15 percent. Such volatility, whatever the result, is rarely good for investors in the long term. While the recovery is good for domestic consumers in the near-term what does it mean for them later on?
Let's first discuss how we got here. In the summer of 2018 the Turkish lira entered a full-on currency crisis with the dollar appreciating considerably against the Turkish lira. Tighter regulations of "off-shore" lira coupled with rate hikes allowed the lira to appreciate by over 25 percent from the height of the crisis. The lira stayed there for much of the fall and winter with no major spikes for several months. On Friday that all changed. With near $15 billion worth of foreign investors pouring money into the carry trade in Turkey, exchanging dollars for liras and investing in high-yield Turkish bonds, equity and bond markets have been dominated by a foreign influx of capital. Spooking those investors caused a stampede on Friday.
The Turkish government stepped in late Friday and assured investors there was no unexpected draw down of central bank foreign reserves. It also took steps to further tighten controls on offshore speculation of the Turkish lira, making "shorting" the lira very expensive and almost impossible. This quickly stabilized currency markets, allowing only those with liras in hand the ability to exit their lira positions. It also had an unintended consequence of making it difficult for those that had entered complex "swap positions" to easily unwind them. While this liquidity crisis for foreign investors is only temporary and will soon abate, the question remains, what will the long-term impact be on the Turkish economy?
In a working paper published by researchers at the International Monetary Fund (IMF), authors Ishii, Otker-Robe and Cui conclude that limiting offshore use of currencies "could be effective if they were comprehensive and effectively enforced, and were accompanied by consistent macroeconomic policies and structural reforms." It goes on to say that these measures may "adversely affect investor confidence and financial market development." The trade-off here being, will the Turkish government utilize the time it has purchased (should it comprehensively and effectively enforce these regulations) to invest in value-added sectors that will help the real economy grow?
If the answer is yes, then the temporary hit to investor confidence and financial market development may be well worth it; if the answer is no, it will take years to recover. Turkey has entered into a new phase now where it has no other choice but to invest in these sectors and implement structural reforms for its future to be bright.
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