It may be time for capital controls

We have started to witness extraordinary times in economic management. The Justice and Development Party (AK Party) government has succeeded in transforming an ordinary “sudden stop” event, very common in open market economies with high current account deficits (CAD), into an intentional plot against them. A witch hunt season has begun.
controlling capital flows Tuesday, the Banking Regulation and Supervision Agency (BDDK) decided to investigate foreign exchange deals in order to uncover alleged “manipulations” following the central bank auctioning of $1.3 billion in a single day. The BDDK wrote to banks asking for details of the auction bids and for what purpose they had bought foreign currency. Last month, while the Gezi Park protests and massive sales of assets in the İstanbul stock market were taking place, Turkey's Capital Markets Board (SPK) had launched an investigation into selling orders. Investors exiting Turkish markets and the lira selloff have essentially been caused by the US Federal Reserve (Fed) announcement that the quantitative easing -- in other words, the systematic purchase of assets from the financial market -- may be terminated in 2014 if the recovery of the US economy is still underway. Political tensions provoked by the Gezi Park protests certainly affected, at least to some extent, the amount of capital outflows, but it is not principally responsible. The AK Party government is holding an obscure “interest rate lobby” responsible for markets fluctuations and claims that it is out to hurt AK Party rule by damaging the image of the Turkish economy. Now, the AK Party government is continuing forward with this logic and has started a series of investigations. I do not think that these investigations will be able to uncover any manipulations of finance markets; it will simply find speculation. The difference between manipulation and speculation is obvious. Manipulation aims to affect prices, while speculation aims to react against expectations of radical price changes. I do not know any law prohibiting speculative actions in a market economy allowing free capital movement and the freedom of financial transactions. After the Fed's announcement, capital outflows occurred in many emerging markets, but I did not hear any blame being placed on plots organized by international lobbies in these markets. It is quite natural for investors to look after their profits. If the majority of them start expecting a rise in local interest rates due to a rise in US interest rates and an excess in demand of hard currencies enabling depreciation of the local currency, they start to sell their assets in the local currency and purchase euros or US dollars; it's as simple as that. Accusing those investors of being a part of an “interest rate lobby” plotting against the AK Party is nonsense. The climate of suspicion created by these accusations confirms my earlier worries. From June 10 to 24 I wrote three articles warning AK Party managers against leading the Turkish economy down a dangerous path. I said an open market economy's management cannot be based on fears of conspiracies but instead it must act according to policies that respect its market rules. Now, the AK Party's allegations have taken the central bank's monetary policy prisoner, and it cannot raise its interest rates without being accused of being a part of the “interest rate lobby.” What is happening now? The market interest rates of treasury bonds are actually over 9 percent, while the central bank is obliged to provide liquidities at 6.5 percent, in the best case. As long as investors think the central bank cannot move and that the Turkish lira will depreciate further, excess demand for hard currency will persist. So, the central bank will be continuing to desperately try to prevent this depreciation by selling dollars. Obviously, this is not a sustainable policy. Actually, the Fed is trying hard to convince investors that it has been misunderstood and that it will pursue its loose monetary policy for a while. This move may calm markets to some extent and for some time stop current capital outflows. But sooner or later, the Turkish economy will be facing capital outflows since its CAD is on the rise. There are only two options to tackle these outflows: Either the central bank raises its interest rates, or the government decides to establish controls on capital movement. The first option is off of the agenda under the current circumstances, which leaves the second option. Different kinds of capital controls aiming to mitigate the volatility of capital in and out flows exist in various emerging markets. Turkey may be part of them. Nevertheless, the AK Party does not forget that, quite logically, these controls are set not only for outflows but for inflows as well.