Streetwise Professor

December 22, 2021

Levitating the Lira–For How Long? Or, Erdo Promises the Impossible (Trinity)

Filed under: Economics,Turkey — cpirrong @ 7:01 pm

The Turkish lira is now about 12, a big recovery from its nadir on Monday. I expressed skepticism that Erdoğan’s announced policy of guaranteeing some Turkish bank deposits against an adverse move in the TRY was the cause. As we’ll see in a moment there is something to that. But even if the policy announcement caused all or some of the rebound, my skepticism about the viability of this mechanism remains.

As to the logic behind the policy. In essence, there was a run on the lira, and one way of running was to sell lira on deposit, and buy dollars. A typical bank run is to sell deposits for currency. One reason bank runs are far less frequent today in places like the US is deposit insurance, which is basically a mechanism to ensure that a dollar on deposit will always be worth a dollar of currency. That short-circuits the run dynamics, in which fear that a dollar of deposits will be worth less than a dollar of currency, which induces people to race to convert deposits into currency, which can cause banks to fail . . . leading to deposits being worth less than the equivalent amount of currency.

What Turkey has announced–and note, it has not announced the details so this isn’t really a plan but a sketch of a plan–is equivalent to a form of deposit insurance. Except that here the government is promising the TRY value of deposits will be worth at least a fixed amount of USD or Euros. But the idea is the same. If people are convinced that their deposits will remain pegged to the dollar, they have less incentive to run.

There is a key word in the prior sentence: “convinced.” It might work if people believe it will work. It won’t work if people don’t. So how can they have confidence? This confidence is necessary, but not sufficient, for success.

The confidence depends on the reliability and solvency of the guarantor. It’s not quite clear who that is in this situation. Is it the banks? The government? The former would be ludicrous, so let’s go with the latter.

So how is the government going to fund the guarantee? It’s likely hoping that the mere fact that people believe it can and it will will mean that the government is never on the hook for anything.

But that’s not realistic. The value of the TRY will fluctuate for the same reasons that currencies always fluctuate. Macro shocks. Balance of payment issues. Capital flows. Whatever. The Turkish government is short a put on the currency (that’s essentially what the guarantee is–a put on the TRY). Sometimes these factors are going to push the TRY down, obligating the government to make good on its promise.

So how is it going to pay for that? And note that it will have to pay a good fraction of the time. Roughly 50 percent of the time if the floor is set at the current exchange rate.

Print lira? LOL. So the lira declines, and the government prints more lira to pay off on its short put. Which will depress the lira further. Requiring more printing, etc. etc. etc.

Short put=short gamma. Short gamma can create an unstable positive feedback mechanism, and positive feedback mechanisms in economics very often have extremely negative consequences. Lira declines feed further declines. And again–as with any currency, lira declines are always a major risk. This is especially true with a country like Turkey. And resorting to this mechanism would likely destroy the trust that it depends on.

OK. The printing option seems pretty dumb–though don’t put it past Erdo! So, to meet its obligation to top up lira-denominated accounts to compensate for a decline in the TRY, instead of printing lira Turkey could sell dollars and Euros for lira which it then gives to depositors. At least this would potentially create a beneficial (negative/stabilizing) feedback mechanism, with the $ and € sales tending to increase the value of the lira.

But where is Turkey going to get the dollars and euros? That’s what I meant the other day when I said don’t trust a madman whose mouth writes checks his wallet can’t cash.

This second mechanism can be viewed another way: as a commitment device. Specifically, a device committing Turkey to defend the lira. Effectively, a way of committing to a peg: it has to buy lira/sell $ or € when the lira declines. And if Erdo’s other promise–not to raise interest rates–is believed, committing to a peg and foregoing the option to raise interest rates to defend the currency.

And if this is the real plan, it faces all the risks that pegging inevitably entail. Pegs are always at risk to speculative attack. Turkey is particularly so, given its paucity of foreign exchange reserves and its bizarre government policies. No doubt George Soros’ interest has been piqued.

This is why I am skeptical. Skeptical as to the announcement of this sketch of a plan leading to a 33 percent rally–FX traders no doubt have figured out what I just laid out. Skeptical as to the feasibility and stability of this mechanism, even if it did levitate the lira.

And as I alluded to at the outset, it may well be the case that the plan didn’t raise the lira on Monday and keep it there–traditional government intervention has. The FT reports that the central bank has spent billions of dollars in recent days to stabilize the TRY. This suggests that the plan is basically just propaganda to (a) conceal what is really going on behind the scenes, a traditional defense of the currency, and (b) allow Erdo to take credit for the rally without admitting that more dollars are going out the door.

Regardless of the mechanism, defending the lira puts strains on Turkey’s public finances. The fact that Turkish credit spreads have widened even as the currency has strengthened suggests that Mr. Market has figured that out.

Turkey, like all countries, faces the “impossible trinity.” A country cannot have a fixed exchange rate, an open capital account, and an independent monetary policy. But Erdoğan is promising all three. Fixing interest rates at low levels as he promises, because he’s on a mission from Allah=independent monetary policy. He has promised to maintain free movement of capital. And now, he is implicitly promising to fix the exchange rate.

We know with metaphysical certainty that this is impossible–the “impossible trinity” phrase came about for a reason. So it’s going to end badly. The only question is which part of the trinity is Erdoğan going to jettison. Based on form, I predict the lira.

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  1. Putin is smiling, rarely do the stars align quite like this.

    Comment by JJK — December 22, 2021 @ 8:32 pm

  2. ‘A country cannot have a fixed exchange rate, an open capital account, and an independent monetary policy. But Erdoğan is promising all three.’

    Just keeps getting better.

    Comment by Ex-Global Super-Regulator on Lunch Break — December 23, 2021 @ 3:26 pm

  3. Well, you cannot deny that the action in the Turkish Lira has been entertaining, even exciting.
    B’berg has it at 10.6386 on this Boxing Day evening.
    One can only imagine the smell of burned fingers of Mayfair hedgies. Yep, there must be quite a few cindered digits.

    Of course, the reserves of dollars and euros will run out sooner or later so the collapse can then continue. There are a lot of hedgies who might fancy their chances; they ain’t gonna be scared off so easily. I’m not sure that Erdogan engenders that much blind faith in his followers any more. It’s one thing to give the guy your vote; quite another to entrust your hard-won pennies to a bank on the basis of his promises.

    Personally, I intend to keep my fingers out of the fire and will watch the fray from a safe distance – munching on popcorn 🙂
    If I wanted to bet on anything, it’d be on capital controls – Argentina 2001 style. State of Emergency, suspend the Constitution, defer Presidential elections forever, root out the furry foreigners conspiring against the great neo-Ottoman project, blah blah ….

    Comment by Simple Simon — December 26, 2021 @ 12:27 pm

  4. @Simple Simon. If I didn’t have good Turkish friends I’d be inclined to agree re the entertainment value.

    And yes, Erdo may prefer capital controls to another TRY implosion. Close call.

    What we are seeing is a classic battle between those betting against a currency and a government trying to defend it. The battle always ebbs and flows, with casualties on both sides. But Turkey just fired off a lot of its ammunition. That may be just what a BSD like Soros has been waiting for. USDTRY is a much more attractive short at 10+ than at 12 or 15 or 18, especially given how much Turkey had to spend in order to push it to that level, and hence how much less it has left. And it was attractive at 12 or 15.

    Comment by cpirrong — December 26, 2021 @ 6:41 pm

  5. From the FT today:
    “Turkish regulator files criminal complaints over lira’s moves

    Allegations of exchange rate manipulation in social media posts during market gyrations”

    It’s started. It looks like back to the future in Turkey (1970s and 1980s)

    PS I didn’t mean to make light of your friends’ predicament. Much as it pains me to admit, BTC does have a compelling use case when it comes to capital controls. My guess is that it is only a matter of time before the crypto exchanges come under fire

    Comment by Simple Simon — December 28, 2021 @ 8:26 am

  6. @Simple Simon. Yeah I saw that and laughed. Going after economists. Hilarious. I never knew we were so dangerous. I seriously wonder if I could go there now. What I’ve said was far more incendiary than what those guys did.

    No worries re my friend.

    Comment by cpirrong — December 29, 2021 @ 12:48 pm

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