Foreign Investors Waking Up To Turkey?

This is a follow up to my earlier article “Is Turkey Headed for Financial Crisis, Again?”

I may have been quick to judge that “there is a severe lack of understanding by international investors of the dynamics that shape the Turkish economy and its financial landscape”. It seems that at least a London-based newsletter, Emerging Markets Monitor, has good insight into the dynamics of the Turkish markets as they elaborate on their former bullish recommendation:

Our short-term bullish view of the Turkish lira continues to play out. Having first promoted potential upside in late June (2006) around the TRY1.5800/US$ area, the currency has appreciated by some 5.8% to its present (August) level of TRY1.4480/US$, in addition to over five weeks of superb carry. With overnight rates trading above 17.50%, and potentially heading a little higher over coming weeks as the central bank acts to cap inflation, the carry is the most attractive in town…

It couldn’t be put better. For those who are familiar with the covered interest rate parity condition, the above statement shows a gross violation in Turkey. The rule states that the home currency should depreciate if it yields higher real returns than the foreign currency. However, as the rest of the world enters the Turkish markets (i.e. home currency) to take advantage of high rates offered, the currency appreciates as a result of surge in demand. Apart from adding to the nation’s spiral of debt, real interest rates this high create real arbitrage profits for macro funds. In other words, Turkish citizens pay taxes in part to subsidize the carry trades executed by these professionals.

Below is a graph of how the Turkish Lira behaved since 1990 after inflationary effects were taken into consideration in both CPI and PPI terms. Note that both the 1994 and 2001 crises are associated with a sharp adjustment (fall) in the exchange rate. You may also see a brief drop corresponding to May and June of 2006, when world financial markets were roiled with a selling pressure upon comments made by the Federal Reserve regarding inflationary pressures. The Central Bank of Turkey aggressively defended the currency by raising interest rates by a total of 4.25 points, which practically stopped the developing trend of another free fall. While the intervention was seen as a successful defense of the Turkish markets against global financial pressures, it was indeed a false move that only retarded the correction of the overvalued currency by market forces.

As the newsletter indicates, monetary authorities defend the outrageous level of interest rates as a tool to combat inflation. Indeed, if all other things were equal (ceteris paribus), restrictive monetary policy would take extra liquidity out of the markets, thus helping to combat an increase in the price level. However, given the much shallower capital markets in Turkey, the “hot money” that enters the country sooner or later starts chasing after domestic goods. When added to the relatively shallower markets, this amount of liquidity actually expands the money supply, paradoxically creating inflationary effects. Monetary authorities have, perhaps inadvertently, expanded the money supply while inviting the “deep-sea sharks” into shallow waters by practically throwing money after them. This was done in order to defend the overvalued exchange rate because an upward movement would “pass through” inflation via more expensive imports.

Turkish economy thus finds itself in the absurdity of combating inflation by maintaining an overvalued exchange rate and in doing so creating inflation by inviting huge amounts of liquidity from abroad. If you wonder whether Turkey is going to face another crisis, my answer is that Turkey is already in a crisis, although not a financial one.

Comments

[Suna Reyent]

Looking back to the article, the part where I talk about interest rate parity conditions sounds misleading. I should have explained myself better:

The forward currency prices observed in the market reflects the interest rate differential between two currencies. In the case of Turkish Lira, the forward price is always quoted at a discount to the current exchange rate, because the interest rate for the home currency (Turkish Lira) is always greater than the interest rate for the foreign currency (dollar or Euro).

So if someone wishes to either hedge or take a position, specifically a short position in the Turkish Lira via dealing in the futures market, they will have to take the forward discount into consideration. Given that the Turkish Lira has actually strengthened in the past due to high interest rates as opposed to weakening, taking a position in the futures markets has been a questionable trade especially on the short side.

There's no violation in the strict theoretical price but the theoretical price in terms of forward discount never actually got realized in the past till expiration due to the strengthening effect of the high interest rate, which is the opposite of the effect that's observed in the TL forward prices due to the covered interest rate parity condition.