Turkey’s Lira Weakens as Economists Sound Alarm Over Unsustainable’ Policies

Turkey’s lira faced a decline in value following the re-election of President Recep Tayyip Erdoğan, as economists cautioned against the sustainability of the country’s policies. Analysts believe that Erdoğan’s strategy of maintaining low interest rates and implementing emergency measures to support the currency is no longer viable, with dwindling currency reserves and a fragile $900 billion economy posing significant challenges.

As trading resumed in London after a public holiday, the lira dropped by 0.6 percent against the US dollar, reaching a near record low of 20.2. Liam Peach from Capital Economics in London emphasized that the current policy stance is untenable, noting that Turkey cannot continue with low interest rates, loose fiscal policy, and depleting foreign currency reserves indefinitely.

Turkey’s reserves have diminished by approximately $27 billion this year as the country attempts to bolster the lira and finance a near-record level current account deficit. Official figures put the reserves, including foreign currency and gold, slightly above $101 billion. However, JPMorgan indicates that net reserves, after factoring in liabilities and excluding borrowed funds from the local banking system, are effectively zero and even deeply negative.

Goldman Sachs economist Clemens Grafe warned that reserves are approaching levels seen in the past when lira volatility sharply increased. Despite these concerns, President Erdoğan affirmed his commitment to the low-interest rate policy, despite the current inflation rate exceeding 40 percent. Erdoğan expressed confidence in his ability to manage the situation, stating that the central bank’s main interest rate had been reduced to 8.5 percent and predicting a decline in inflation.

Investors are also worried about the government’s liability for special savings accounts totaling $121 billion, which will pay out in the event of lira depreciation. While this measure has slowed the purchase of foreign currencies by Turks, Finance Minister Nureddin Nebati revealed that the accounts have cost the country approximately TL95.3 billion ($4.7 billion) since their introduction in 2021. The financial strain on the government could escalate rapidly if the lira depreciates further.

Analysts suggest that Erdoğan might seek new funding from Middle Eastern allies and Russia. The president previously mentioned that unspecified Gulf states had contributed funds to stabilize Turkey’s markets, although details were not provided. Additionally, the influx of cash from summer tourism could temporarily alleviate financial pressures, according to Wolf Piccoli of Teneo consultancy.

Turkey’s Bist 100 stock index, buoyed by local investors seeking refuge from high inflation, surged by over 4 percent on Monday. It has generally benefited from inflation as local investors search for opportunities that can compete with rapid consumer price growth. Some economists speculate that Erdoğan may form a new economic team, potentially bringing back familiar names to reassure foreign investors.

While the election is over, attention now shifts to the composition of the economic team and the credibility of the initial policy response, as highlighted by Ilker Domac of Citigroup. However, Domac cautioned that it will become increasingly challenging for Turkey’s central bank to maintain interest rates significantly below inflation, particularly in the last quarter of the year and beyond. More pessimistic economists, such as Atilla Yesilada from GlobalSource Partners consultancy, warn of the potential need for formal capital controls or significant deposit flight from the banking system.