Turkey is in the throes of a currency crisis that is threatening to turn into a banking crisis. So, of course, its government just announced it is about to . . . reduce spending?
Apparently, yes. In a bid to convince investors it is reembracing the financial orthodoxy it has been flouting for the past few years, Ankara is now saying it is going to cut the budget by $10 billion and trim its growth target from 5.5 percent to 3.8 percent. The fact that the government is being more realistic about how fast its economy can expand without setting off the kind of inflationary spiral that has happened recently — prices have risen 17.9 percent the past year — is genuinely good news. But the rest is completely beside the point. Turkey’s problem is not that its government has been spending too much money but, rather, that its banks have been borrowing too many dollars.
To be fair, Ankara also said it will perform “health assessment studies” on its banks soon. It is just hard to know whether that will be an attempt to fix things or a bit of Kabuki to pretend they don’t need to be fixed. Given the government’s track record of choosing the easy wrong over the hard right, it is tough to be optimistic. Either way, there is still one thing we can say for sure: Turkey will continue being stuck in an economic Catch-22 in the meantime.
The short version is Turkey’s banks are going to get into trouble if the lira keeps falling — it is down 40 percent since the start of the year — but that they will be in trouble for a different reason if the government acts to prop up the currency.
The slightly longer version, meanwhile, goes something like this. For the last eight years, Turkish banks have borrowed a lot of dollars they have then lent to Turkish companies to finance a nationwide building boom including upscale shopping malls, Ottoman-style mosques and even state-of-the-art airports. The problem with borrowing money, however, is you eventually need to pay it back. And the problem with borrowing foreign money is it might have become more expensive by the time you do pay it back.
Your debts, in other words, might be much more difficult to manage if you are getting paid in Turkish lira that are falling in value against the U.S. dollars you owe. At which point, the banks that lent you those dollars might find themselves on the hook for greater losses than they had anticipated. That is why Goldman Sachs thinks Turkish banks could run through all the extra capital they have built up as a buffer if the exchange rate drops from its current level of 6.2 lira per dollar to around 7.1 per dollar.
It seems pretty simple then. Turkey’s government needs to stop the nation’s currency from falling too much farther to keep companies from defaulting on all their dollar debts. That means the government has to increase interest rates quite a bit.
The idea is that higher rates will make it more attractive for investors to keep their money in Turkey rather than move it back to the United States in response to the U.S. Federal Reserve’s own rate hikes. But that is something investors have done only grudgingly so far. The reason for that is that Turkey’s increasingly autocratic President Recep Tayyip Erdogan subscribes to the extremely incorrect theory that higher interest rates cause, rather than cure, higher inflation. As a result, he thinks that higher interest rates are “the mother and father of all evil” and “a tool of exploitation” that a shadowy “interest-rate lobby” is supposedly trying to force onto the country for their own nefarious (and, in some cases, treasonous) purposes. Worse, he has said the Turkish central bank’s independence does not mean it can “set aside the signals” he is giving it — and has granted himself the power to appoint the central bank chief and installed his son-in-law as the finance minister.
But it is not just a matter of overcoming Erdogan’s opposition to what the economy needs. The central bank has implemented its own economic policy over the president’s directives in the past. Indeed, it just raised rates more than was expected, all the way from 17.75 percent to 24 percent, despite Erdogan’s predictable histrionics and ham-handed attempts to control it.
The real issue is what these higher rates will mean for Turkey’s banks.
If interest rates rise too much, it could leave the banks in a position where they themselves are paying more to borrow than they were charging people to borrow from them. So they would still be facing losses (just not for as dramatic a reason as companies being unable to pay back their dollar debts). This could scare off investors enough that the lira might continue to fall even though interest rates are rising. The government would run out of money to pay for the things it needs to import — in particular, energy — and would have no choice but to go to the International Monetary Fund for help.
The point, then, is the root of all of Turkey’s problems are its banks. They are why the falling lira is so dangerous to the economy and why stabilizing it could be dangerous, too. The government needs to recapitalize its banks — and fast.
Otherwise, Erdogan’s conspiracy theories about foreigners bringing down the economy might end up being true — but only because he had allowed it to get to the brink of collapse.