High Rates Fostered an Unsustainable Economy Which Turkey Must Painfully Rebuild

Like several currencies of developing nations that are propped up by high rates, the Turkish Lira is built on an unsustainable, crumbling foundation. For every year since the Great Financial Crisis, interest rates in Turkey have been seven to twenty percentage points higher than they have been in the United States, directly causing two harmful conditions in the Turkish economy. First, private sector actors are heavily incentivized to take out debt in foreign currency. Second, international investors do not value Lira for the real goods and services they can buy with Lira; they instead want Lira deposits so they can passively earn more Lira which they can exchange for more valuable currencies. The long-term solution to the first problem is to drastically and permanently cut interest rates, but because the second problem is still in effect, doing so will cause severe harm to the exchange rate and the Turkish economy in general before the benefits of fixing the first problem are fully realized. In other words, Turkey must painfully tear down its financial system before it can slowly rebuild a sustainable economy.

Firms tend to borrow more in whichever currency has the lowest interest rate, and Turkey is no exception. A 2009 study by the Swiss National Bank on 26 transition countries found that “when foreign currency funds come at a lower interest rate, all foreign currency earners” in addition to “local currency earners with high revenues and low distress costs” choose foreign currency loans. Similarly, a 2001 study from the Journal of European Financial Management on Finnish firms showed that firms tended to borrow in a given loan currency “when the nominal interest rate for the loan currency, relative to other currencies, was lower.” In Turkey, private banks “binged” on loans in dollars because interest rates were lower and lent them to Turkish firms, “which preferred loans in dollars rather than Lira due to the cheap interest rates on offer.” In addition, the Turkish government guaranteed Lira and foreign-denominated loans to individuals and businesses equaling 673 billion Liras (over one third of Turkey's GDP) for which it could not fully reimburse private banks, instead opting for restructuring in some cases. For example, the Turkish government's largest development bank, Eximbank, facilitates tens of billions in state-guaranteed credit, and 90% of its loans are denominated in foreign currencies (for comparison, the equivalent institution in South Africa, the Export Credit Insurance Corporation, keeps between 20% and 50% of its financial assets in foreign currency, depending on the year). At some point, seventy percent of Turkey’s economy consisted of foreign-denominated debt, more than any other emerging market. As of October 2021, only 2% of long-term private debt and 22% of short-term private external debt is denominated in Lira. In total, only 3% of external debt held by the private sector in Turkey is denominated in Lira. In contrast, according to a 2021 study, the private sector in typical emerging market economies has 10% of their external debt denominated in local currency. In other words, the stability granted by local currency loans is three times smaller in Turkey than in most developing countries.

Of course, if you take out a loan denominated in dollars, you must pay it back with dollars; Turkish firms have some revenue in dollars, but most is in Lira, making it difficult to repay dollar-denominated loans if the value of the Lira ever drops. If Turkish companies sell Lira to pay these loans or the value of the Lira drops for any other reason, the value of Turkish stocks and bonds drops, causing foreign investors to pull their money out of Turkey by selling Lira, “worsening the rout” and leading to a cycle of depreciation and default. In other words, once a country has a large amount of foreign-denominated debt, a small shock can quickly snowball into a currency crisis. There have been reports of Turks rushing to currency exchanges to buy dollars with their Lira savings, which is certainly accelerates the depreciation and may have caused it in the first place.

This large foreign-denominated debt weakened Turkish economic agency by disrupting the Cascade of Liabilities. When a large part of the economy has liabilities denominated in a given currency, they will eventually start demanding payment in that currency. Normally, the Cascade of Liabilities is dominated by the government making businesses pay tax in its currency and by those businesses passing that currency liability to their customers, both foreign and domestic. But when businesses begin to have large liabilities denominated in another currency, they begin demanding payment in foreign currency, reducing the demand for the government’s domestic currency. This is exactly what happened in Turkey. As the need to get dollars and euros to pay these loans became more dire, Turkish companies which normally accept Lira began forcing customers and tenants to pay in dollars, giving them no choice but to rush to financial markets to buy dollars, “pushing down the value of the Lira even further.” By 2022, Turkey was highly dollarized, with prices of consumer goods including food, clothing, and cars being priced in dollars. Because these businesses had large foreign currency liabilities, they demanded foreign currency in payment, meaning the Lira was not only less valuable internationally, but it was less valuable within Turkey. Because the Lira could not purchase as much domestically, the Turkish government’s economic agency–its ability to purchase everything for sale in its own currency–was drastically weakened.

In addition to incentivizing foreign-denominated private sector debt, high interest rates attracted speculative capital to Turkey. Because rates were 15% or higher for years, Turkey attracted billions of dollars from investors who only wanted Lira so they could passively accumulate it and convert it into dollars or euros. When countries pay nothing in interest to their depositors, people will only accumulate that country’s currency so they can buy semi-unique real goods and services from that country, which I call the Cool Stuff Hypothesis. Such accumulation is what I call "cold money." However, if a country promises a substantial return, people will also accumulate that currency solely for the purpose of buying other currency with it, what many call "hot money". This is what happened with the Lira. The promise of double-digit returns attracted foreigners to hold Lira deposits even though they had no intention of buying Turkish goods and services. If they only cared about buying Turkish goods and services, the exchange rate would hardly matter, but–for these hot money investors–since they had no desire to buy Turkish goods and services, the exchange rate was the only thing that mattered, so once it began to fall, they had little reason to continue holding Lira, so they sold their Lira, creating a snowball effect that pushed the exchange rate down even further.

Before the exchange rate began to fall, high rates created a false demand for Lira that temporarily allowed Turkey to issue more Lira than the world would have otherwise desired to save. Instead of being rooted in the demand for Turkish goods and services, demand for the Lira was propped up by the promise to give foreigners more Lira which they could exchange for dollars and euros. This artificially raised the value of the Lira to a price that the amount of Cool Stuff produced by Turkey could never justify on its own. Because the Lira was overvalued, for a while, Turkey could deficit spend in Lira without harming the exchange rate and causing pass-through inflation. A zero-rate policy would have caused Turkey to develop more slowly, but with more stability by relying on cold money. If Turkey had kept its domestic interest rate at or near zero, the Lira would not have been so overvalued, but because a much larger percentage of private sector debt would have been denominated in Lira, the Lira would also not have been vulnerable to dramatic swings that crashed its value. In other words, foreign investment would have been smaller but less likely to flee upon fluctuations in the exchange rate, and those fluctuations would have been less frequent and smaller because the private sector would have less foreign-denominated debt.

The only way to achieve this slow and steady development is to continue cutting rates, all the way to zero, although these cuts will cause much turmoil before stable development can occur. Because so many Lira deposits are held by investors who only hold Lira because of its high interest rate, if the Turkish government reduces interest rates, these hot money investors will sell Lira, pushing the exchange rate down. Eventually, if Lira interest rates approach zero and all the hot money is purged, the exchange rate will stabilize and slowly begin rising. In the meantime, Turkey should attempt to use capital controls to potentially convince some hot money investors to keep their Lira in spite of low rates, essentially converting some of this hot money to cold money–where the value of the currency is anchored by the goods and services for sale in that currency. Once much of this hot money has been removed or replaced with cold money, Turkey can sustainably rebuild. There has been some small progress towards a cold money economy in recent years, as Turkey has lowered rates. During this process, the Lira has predictably depreciated—sharply. Fortunately, private external debt in Turkey has also fallen sharply, as Lira loans have become slightly more affordable.

Despite this small progress, Turkey has not committed to this transition. This week, President Erdogan announced a plan to guarantee the value of Lira deposits by promising to reimburse depositors for any decline in the Lira exchange rate. This has slowed the depreciation of the Lira for the time being, but within two years, this policy will reveal itself to be harmful and misguided because it continues to incentivize holding Lira for the purpose of buying other currencies, rather than to buy real goods and services from Turks. This policy promises to give Lira depositors extra Lira if the exchange rate falls, but giving currency away for nothing does not make it more valuable. Giving Lira away to people who already have it will increase wealth inequality and financial asset prices and could also increase the prices of consumer goods in Turkey.

Instead of promising to reimburse Lira holders, Erdogan should focus on reducing the collateral damage from the depreciation caused by interest rate cuts and setting up financial institutions to foster Lira denominated credit growth. Instead of draining its foreign currency reserves by purchasing Lira, Turkey should have invested in improving domestic capacity to produce the goods and services which it currently needs to import. For example, Turkey is a net importer of energy, so Lira depreciation will lead to increased energy prices. Rather than trying to force a particular exchange rate by buying up Lira, Erdogan should invest in domestic energy production to reduce the need for energy imports, which will become more expensive as he continues to cut rates. In addition, once interest rates are low, private banks may be reluctant to lend at minimal profits. To remedy this and ensure a steady stream of Lira-denominated credit growth, Erdogan should set up programs through the Turkish Central Bank which can lend directly to individuals and nonfinancial businesses, solely in Lira. These new programs must replace the current system through which state banks guarantee and later repudiate loans through private banks in both Lira and foreign currency. It must also strengthen banking regulation to prevent excessive or speculative lending in its new, low-interest environment. Once the private sector in Turkey rebalances its portfolio, Turkey can resume sustainable development.