Drug-like effects of capital inflows to Turkey

Inflation is rising. If the Central Bank manages to somewhat handle inflation without doing much to interest rates, there is one explanation for this: Capital inflows. To be more precise, “hot money” inflows into Turkey help to keep the exchange and long-term interest rates at “moderate” levels.

But this won’t last too long. Indeed, that reality is what we have witnessed over the past few months. When it recently downgraded Turkey, Moody’s cited the erosion of institutional strength in the country. Its move was denounced by the government as “politically motivated.”

Capital inflows prompt some analysts to say the rating downgrade will have little impact on the markets or encourage central bankers to not do their jobs. But there has been a capital outflow over the past five weeks. Last week, there was a portfolio outflow of $689 million that brought cumulative outflows to $153 million since the start of the year.

“Hot money” inflows may keep things going for a while but in the end we will have to face reality. That is what happened after 2009. The cost of complacency is always dear.

This only happens in Turkey. Crude efforts to lower interest rates gain momentum, even though such efforts are totally out of touch with reality. Politicians talk about cutting interest rates but eventually officials are forced by conditions to raise rates.

The Central Bank appears to think that time will do the job for it: Inflation will eventually decline anyway so inflation expectations deteriorate whenever capital inflows weaken and inflows reverse course. As a result, interest rates end up rising.

Current account deficit speaks the truth

Turkey’s current account deficit this year increased by some $17 billion compared to last year and the shortfall was financed by “hot money” - portfolio investments that increased as much as the deficit.

Portfolio investments help the Turkish Lira. The currency is not appreciating against foreign currencies but remains at a high plateau. In the event of capital outflows, the exchange rate rises again. It did not come as a surprise that the lira depreciated by 2.5 percent and bond yields rose by a half point in the week after Moody’s downgraded Turkey. Economic fundamentals and the political outlook eventually bring all parameters to where they should be.

Facing realities

Unfortunately, politicians are continuing to tell different stories to voters in order to cover up their mistakes. Without explaining why interest rates fell before Turkey’s 2013 Gezi protests, they claimed that rising interest rates afterward were “aimed at blocking Turkey’s development.”

Before the Gezi protests, the 12-month trailing current account deficit was $51 billion, more or less what the shortfall is today. Capital inflows stood at $96 billion. In any country, interest rates drop if capital flows are twice the current account deficit. In fact, interest rates declined at that time, but this was not because of the policies we implemented. It was rather because of the glut of money in the world economy. After the economic crisis in 2009, developed countries pumped money into the markets and the abundant money had nowhere else to go. Turkey was one of the main beneficiaries and interest rates therefore declined.

So what happened next, when capital started leaving the country? In 2013, then-Federal Reserve chairman Ben Bernanke signaled that the U.S. Federal Reserve would cut the pace of bond purchases. This triggered market turmoil that came to be known as the “taper tantrum.”

The Gezi protests coincided with Bernanke’s announcement, and Turkey’s political outlook has deteriorated ever since. The last five years have seen consecutive political crises.

Developed countries resorted to printing money to overcome the economic crisis. Because of the resulting capital inflows into emerging economies such as Turkey, local politicians became complacent. Those inflows gave them the luxury to make mistakes. But Turkey has now entered a period in which we will have to face the consequences of the realities that politicians have so far tried to escape.