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The Turkish lira experienced a sharp decline of 7% on Wednesday, signalling a shift in the country's economic strategy. The newly re-elected government is abandoning its previous approach of tightly controlling the currency's value at all costs.
Turkey has a history of financial challenges, and the weakening lira poses significant difficulties for the country’s economic decision-makers. The currency’s fall has been linked to several factors, including a large budget deficit, high inflation, and a lack of foreign exchange reserves resulting from questionable policies. The lira’s downward trajectory is uncertain, and it remains unclear where it will stabilize. The central bank’s actions, like capital controls or interest rate increases, will determine the currency’s future.
The Turkish economy could face severe consequences if interest rates increase significantly, potentially leading to a recession or standstill. Consumers would tighten their spending, and borrowing costs for companies would skyrocket. However, the weaker lira may boost exports, particularly during the upcoming tourism season and in the aftermath of the recent earthquake, which could partially alleviate the economic strain. Turkey has experienced a pattern of boom-and-bust cycles, fluctuating between double-digit growth and contraction rates in recent years.
The depreciation of the lira raises concerns about a potential surge in inflation in Turkey. Headline inflation is likely to rise, and it isn’t easy to envision a solution without a substantial interest rate hike.
Turkey now faces the cost of covering the special lira depreciation-protected bank accounts introduced in late 2021 to discourage money conversion into foreign currencies. Additionally, the country has approximately $100 billion of debt denominated in dollars or euros, becoming increasingly expensive due to the weakening lira. This situation poses a problem for borrowers and could also impact banks’ balance sheets if they have adequately hedged against the risks. The repercussions could extend beyond the financial sector, with potential wider implications.