After Naci Ağbal, the governor of the Central Bank of Turkey was fired, Turkey's lira and stocks suffered greatly and its government bond experienced the biggest weekly selloff. On the 22nd of March, the first trading day after the head of the central bank was removed, the exchange rate of the Turkish lira against the U.S. dollar plummeted to a ratio of 8.4: 1, a decline of 17%, hitting a new low since August 2018 and almost collapsed. On the same day, the yield on Turkey's 10-year government bond soared to 18%. It rose by more than 400 basis points in a single day, the largest increase in history. The trading volume of Turkish U.S. sovereign dollar-denominated bonds exceeded USD 1.1 billion, roughly three times the monthly average daily trading volume since the beginning of 2019. The stock market has also been continuously declining. On March 22, the Borsa Istanbul (BIST) 100 Index of Turkey experienced circuit breaker twice. As of the close, it fell by 9.79%, the largest one-day decline since June 2013. And on March 23, the index plummeted 7% throughout the day and triggered a secondary circuit breaker in two consecutive days.
The good news is that there were no major fluctuations in the Turkish exchange rate on the 23rd of March. That being said, the turbulence caused by the sharp drop in the Turkish capital market may cause the Turkish economy to collapse under high inflation and a new round of crises will appear. If this kind of panic spreads among international investors, it might even lead to a chain reaction of taper tantrums in emerging markets, leading to a potential new round of economic and financial crises.
The spark that lit the fuse for the Turkish market was the Turkish central bank raising interest rates by 200 basis points to 19% on March 18 in response to high inflation which caused dissatisfaction with the Turkish President Recep Tayyip Erdoğan. This also marks the third time that Erdoğan has replaced the head of the central bank in the past two years. As market investors lacked confidence in the Turkish lira and its capital market due to the sacking of the governor, this led to the withdrawal of funds.
Turkey achieved a positive growth of 1.8% under a series of policy stimulus measures last year, being another G20 country that achieved positive growth alongside China. In 2020, Turkey spurred a 10.3% increase in the total fixed capital formation and promoted the recovery of the economy by extending large amounts of credit to communications, infrastructure, military industry, and real estate. However, this surge in credit investment comes at the cost of high inflation. In February this year, Turkey's inflation has reached 15% while cheap loans have accelerated the decline of the lira exchange rate by about 25% throughout the year. Foreign reserves have been consumed by nearly 50%, and the pressure of external imbalances has increased significantly. Under such circumstances, the central bank of Turkey has raised interest rates several times in response to rising inflation since Ağbal took office in November last year, and the benchmark interest rate has been raised by 875 basis points. Taking into account factors such as Turkey's trade, fiscal "twin deficits", excessive inflation, and abnormally low foreign exchange reserves, the Turkish economy has been in a state of instability. The interest rate hike in March may be the last straw, which will not only bring about signs of a collapse in the capital market, but may very well overwhelm Turkey's economy.
Judging from the continued collapse of the stock market, this may just be the beginning of the crisis. With the withdrawal of foreign capital, Turkey will subsequently face a credit crisis. Statistics show that currently, Turkey's private sector has USD 117.5 billion in short-term foreign debt that needs to be renewed. From March to December this year, the Turkish government will face the pressure of USD 11.6 billion in repayment of foreign debt. Generally speaking, external debt is more sensitive to inflation and exchange rate disturbances, and the rising inflation is putting Turkey's internal and external credit environment in a vicious circle. International credit rating agency Moody's stated on March 22 that the unexpected removal the Turkish central bank's governor will increase the pressure on Turkey's sovereign credit rating as the overall predictability of the country's economic policy is low. Moody's also emphasized that during the tenure of Ağbal, the USD 11.2 billion net asset flows that flowed into Turkey may be reversed into capital outflows in the short term; credit pressure continues to increase after the governor's dismissal. The further increase in deposits of U.S. dollars and gold may lead to increased pressure on the lira.
Currently, the situation in Turkey is evolving in accordance with the logic of the standard emerging market economic crisis. As inflation continues to rise, the central bank has to passively raise interest rates, leading to a reduction in internal and external credit, which in turn is a cause of debt crisis and further economic depression. While this is definitely a result of improper policy choices made by Turkey, from the perspective of ANBOUND however, a deeper reason for this would be the evolution of the U.S.' super-loose policy and changes in the liquidity of the U.S. dollar. Judging from the situation in Turkey, the increase in U.S. inflation expectations as well as the expectations of changes in the Federal Reserve's policy are causing taper tantrums in emerging markets. ANBOUND has previously mentioned that the changes in U.S. inflation expectations and the Fed's policy expectations are in fact caused by U.S. inflation expectations. Although this will strengthen the U.S. dollar, it will also make inflation risks manifest in the more fragile emerging market countries. The market now is highly concerned about whether the crisis in Turkey will spread to other emerging markets and trigger crises in other countries.
In response to the impact of the COVID-19 pandemic, most of the emerging market countries have followed the United States in monetary easing last year, which led to an increase in internal and external debt and a rise in inflation. As U.S. Treasury yields continue to rise, the return of U.S. dollars has caused emerging markets to face the pressure of capital outflows. This change is forcing emerging market countries to raise interest rates in response to capital outflows and rising inflation. Recently, Brazil, Russia, as well as several other countries have raised interest rates successively and Bloomberg predicts that Nigeria and Argentina may also raise interest rates as early as the second quarter. Market indicators also show that policy tightening expectations in India, South Korea, Malaysia and Thailand are also increasing. Of course, the situation in these countries is not as serious as Turkey, and they are not close economic and financial contacts so the risk of contagious direct impact is low. Nonetheless, the problem is that when the Turkish crisis breaks out, if international investors are triggered to accelerate their withdrawal from these markets to avoid risks, the possibility of crisis contagion in emerging market countries will increase significantly. Judging from the market's disagreement on the U.S.'s inflation, this possibility is increasing. Investors are becoming very sensitive in this regard, so much so that certain incidents can trigger them to back out. As a result, the removal of the governor of the Turkish central bank might become the fuse that triggers crises in emerging markets.
Final analysis conclusion:
The turmoil in the Turkish financial market is not only the result of the country's inflation and policy evolution, but also a reflection of the taper tantrums brought about by the changes in the U.S. dollar's super easing. This means that inflationary pressures in the United States and the world are being released from emerging market countries with the most vulnerable economies and it is likely to become the catalyst of a series of similar economic and financial crises in countries of similar conditions.
