The ‘sudden stop' threat

While I asked in this column on Saturday if the “Turkish economy is on the eve of a recession,” Professor Daron Acemoğlu from MIT was speaking the same day at Bilgi University about the risk of a “sudden stop” in the Turkish economy.
Turkish Central Bank became prisoner of the intereset rate lobby discourse  A hot debate is open. Let's first briefly explain the “sudden stop” for readers unfamiliar with the concept. In an economy where capital movements are free, short-term investments and capital inflows can change direction and leave the recipient country very quickly from time to time. The reversal of capital flows depends basically on an eventual risk of capital losses due to a decrease in asset prices. When this eventuality is perceived by the majority of investors, they simply take home their money. A number of factors can cause such behavior, and there is no need to invent an “interest lobby” to explain the sudden stop phenomenon. For a foreign investor who exchanged some amount of dollars into Turkish lira and invested it in Turkish-lira denominated assets, the value of the Turkish lira becomes a decisive parameter. If the majority of investors start expecting an imminent depreciation of the local currency, it is quite rational for them to sell their assets before this depreciation occurs. And when sales begin, asset prices start decreasing. Economists call this a “self-fulfilling prophecy.” Of course the risks and consequences of the sudden stop vary from one economy to another. The lower local interest rates are compared with the expected interest rates of safe assets like American Treasury bonds or Eurobonds, the higher the risk of a sudden stop. The larger the current account deficit in an economy and the more over-financed it is by short-term capital flows, the more likely this economy is to face a sudden stop. And last but not least, the weaker investors' confidence in economic management, the more they are inclined to perceive increasing risks of a sudden stop. Here, we are coming back to the self-fulfilling prophecy. Two out of these three conditions have been present in the Turkish economy since one month ago, roughly. Turkish Lira had appreciated more than what the Central Bank was ready to accept for macroprudential reasons. So it lowered interest rates, aiming to provoke a controlled depreciation of the Turkish lira. The interest rates went so low that expected real interest rates became negative, launching a debate about their sustainability. This debate is fully justified because Turkey still carries one of the highest current account deficits in the world. Moreover, this deficit is mostly financed by short-term capital flows. In this context came Bernanke's statement regarding an eventual tightening of the FED's monetary policy in the future if the US economy continues its recovery. Then US Treasury bonds' interest rates increased slightly. So, most of the ingredients for the sudden stop that started last week were already present in the Turkish economy. As for the investor confidence issue, we can't yet say that it has definitely started weakening. Nevertheless, we should admit that our governors have done all they can in this respect. Accusing an obscure interest lobby of provoking a sudden stop and a rapid deprecation of the Turkish lira as well as a rapid increase of market interest rates is certainly not the right approach to calm down already nervous investors. This is because it reveals an absolutely wrong reading of the events that are happening and at the same time increases worries about the government's ability to properly manage an open market economy suffering from some fragilities. What is most dangerous, I think, in this approach is that it takes the Central Bank's monetary policy prisoner. At the moment, the Central Bank prefers to use its hard currency reserves to end the sudden stop, hoping that outside and inside Turkey there will soon be enough good news to reverse current adverse expectations. However, it may be obliged to use its interest rate weapon, since its reserves are rather limited. If this need appears, it will be not easy for the Turkish Central Bank's management, albeit independent by law, to pull out the interest rate weapon since the government firmly condemns high interest rates as the mother of all badness. To end this article, let me recall the infamous battle former Prime Minister Tansu Çiller waged against market interest rates in November 1993, triggering a full-fledged financial crisis. The Turkish economy today is far more structurally strong than it was in the 1990s and a financial crisis is not likely. But a recession is possible.