Turkey’s Next Challenge: How Bad Can Inflation Get?

After a temporary lull, the Turkish crisis had erupted again. As expected, the half measures of mid-August – to tighten monetary policy without raising the main interest rate, and to attract some support from abroad without changing policies or turning to the International Monetary Fund (IMF) – have not stopped the rot.

Better to act fast

How Turkey’s central bank plans to regain market confidence that it will eventually hit its 5% inflation target again remains a mystery.

Only a credible U-turn in Turkish policies – raising interest rates, submitting to an IMF program and mending relations with the United States and the EU – can support the exchange rate and dampen the surge in inflation ahead. President Recep Tayyip Erdogan does not seem to be close to that yet.

A modest devaluation can help in the end

For a country with a major current account deficit (around 6.5% of Turkish GDP in H1 2018) and a sudden stop in capital inflows, a real devaluation is part of the solution.

A decline in the exchange rate that is not fully offset by a rise in domestic prices provides the incentive to import less and export more.

Severe pain before the eventual gain

Replacing imports with domestic output and shifting resources to export-oriented activities takes time, though.
In the event of a dramatic rather than modest decline in the exchange rate, companies cannot afford the imports they still need. A lack of financing can delay the shift in resources. Output is likely to contract first before it recovers later on.

The more dramatic the plunge in the exchange rate and the greater the lack of trust in the government and the central bank, the worse the temporary damage to output will be.

Price level could rise by 50%

The weakening of the Turkish Lira leads to higher inflation in Turkey. In the past, Turkey’s price level has tracked the decline in the Lira versus the euro pretty well over time. If this trend continues, we should see a significant increase in Turkish inflation over the coming 18-24 months.

Since the end of 2016, the Euro gained 110% vs. the Lira. If 75% of this feeds through into higher prices in Turkey, the Turkish price level should rise by roughly 82% as a result. As Turkish prices have already increased by 23% since the end of 2016, a further increase in Turkish prices by around 50% over the coming 18-24 months would still be in the pipeline.

Looking at previous crisis, assuming a pass-through of an exchange rate devaluation into domestic inflation of 75% does not look completely unrealistic. For example, the pass-through rate was around 100% in Turkey in 2000-2003.

Between Jan 2000 and December 2003, the Euro vs. Turkish Lira exchange rate (EURTRY) rose by 200%, while Turkey’s consumer price index also increased by 200% during the same period.

Contagion risks overdone

Emerging markets are a very diverse bunch. Amid gradual Fed rate hikes in response to firm U.S. domestic demand, emerging markets with elevated financing needs in foreign currencies face problems, while export-oriented countries without such financing needs should do fine.

Even among the major vulnerable countries, hardly any other seems as determined to resist economic logic and maintain misguided policies as Erdogan’s Turkey.

Argentina is in trouble but is adjusting its policies. Despite an initial risk-off reaction among investors, a wave of emerging market crises that could seriously dent growth in the developed world is very unlikely.