Turkey is getting nowhere fast with its “lira-isation” despite introducing more extreme de-dollarisation policies in recent months.

That’s the conclusion of Liam Peach, an emerging markets economist at Capital Economics, who took a look at how Turkish policymakers have doubled down on what they present as their new economic model.

Turkey, it is widely acknowledged, is in one heck of an economic tangle following years of unconventional ‘Erdoganomics’ pursued under Turkish leader of two decades Recep Tayyip Erdogan. Official inflation is running at 83%, versus a benchmark interest rate that was last week cut by 150 bp to 10.5%, while the Turkish lira (TRY) has shed 29% against the USD this year, having lost 44% last year.

Peach acknowledged that the more extreme de-dollarisation policies (with “new measures now being announced almost every other week”—see table at foot of article) appear to have had some impact in terms of stemming lira depreciation, but observed that “the central bank seems to have misdiagnosed dollarisation as the cause rather than the symptom of Turkey’s inflation problem. It’s hard to see the central bank reducing inflation sustainably in the coming years while real interest rates remain deeply negative”.De-dollarisation, noted Peach, “is a multi-year process and the early signs suggest that [in Turkey] it is happening slowly”.

Last December, policymakers introduced a flagship deposit scheme that protects lira deposit holders against exchange rate losses. In September, Turkish Finance Minister Nureddin Nebati said TRY1.3trn had been placed into the scheme, equivalent to 15-20% of all bank deposits.

“This is relatively large,” said Peach, “but the FX share of private sector bank deposits (55% in August) was only slightly lower than a year ago and the FX share of banks’ total assets (48% in August) was higher. CBRT [Central Bank of Republic of Turkey] Governor [Sahap] Kavcioglu admitted in July that ‘no one is converting their FX’.

'Unorthodox experiment'

Unable to raise interest rates—given the adherence to Erdoganomics—policymakers have embarked on what Peach refers to as “an unorthodox experiment called the ‘new economic model’” that concentrates on external rebalancing (reducing the current account deficit) and the “lira-isation” (promoting use of the lira) to lower macro vulnerabilities and inflation permanently.

As part of their framework, policymakers are focused on expanding the use of lira in transactions, contracts, deposits and loans, increasing the use of lira-denominated assets in collateral, reducing FX-indexation and promoting lending for investment purposes and to exporters rather than to consumers. These measures are expected to reduce FX demand and narrow the current account deficit sustainably.

In April, policymakers forced exporters to sell 40% of their FX revenues to the CBRT in exchange for lira (up from 25% in January).

The central bank and banking regulator have raised reserve requirements on certain loans, restricted lira loans to firms with large FX assets, increased the share of lira assets required for collateral and raised the share of lira securities (government bonds) banks need to hold as required reserves.

On top of this, said Peach, banks are forced to hold more bonds if they lend at higher interest rates, lending to corporates is prioritised over consumers and the banking regulator has capped the maturity of consumer loans.

Said Peach: “There are a lot of moving parts but the key point is that these policies are (i) trying to improve current account dynamics by discouraging banks from lending unless loans are used to boost supply (rather than demand) in the economy and (ii) trying to force increased adoption of the lira in deposits and loans and increase holdings of lira-denominated assets among households, firms and banks.”

'Similar effect to capital controls'

The policies are having some impact, with a similar effect to capital controls and are likely to have been partly responsible for limiting the pace of lira depreciation this year, Peach said. Bank lending in foreign currency was now contracting by 20% y/y (in nominal terms), while lira-denominated lending was growing by 70% y/y, he added. Corporate credit growth was outpacing consumer credit by a ratio of 2:1, the largest in four years, Peach also noted, adding that “10-year local currency government bond yields have collapsed from 24% to 12% as banks have responded to the regulations by purchasing bonds.”

Peach cautioned: “There will become a point at which banks become less willing to increase their bond holdings. As we understand it banks will need to reduce the rate of interest on their loans (to comply with the CBRT’s macroprudential measures) or cut lending. We suspect a mix of the two. Interest rates on commercial loans have fallen in recent weeks but anecdotal evidence suggests that credit conditions have tightened as some firms are finding it more difficult to access credit and banks are becoming more cautious about lending. We think a sharp slowdown in credit growth is likely to become clearer from Q4.”

Ultimately, efforts to de-dollarise through force are unlikely to be as effective as policies that naturally make it more attractive to hold lira, advised Peach. “It will be incredibly difficult,” he concluded, “to lower inflation sustainably while the CBRT maintains deeply negative real interest rates. The experience in EMs that have successfully reduced inflation in recent decades is that it could take 5-10 years and requires a combination of improved central bank credibility and tight fiscal and monetary policy (including high real interest rates).

“And on top of this, these “lira-isation” policies present macroeconomic risks. We’ve warned that policies that force firms to reduce their FX assets risks reducing their natural hedge and ability to service their FX debts in the event of further large falls in the lira. More restrictive lira-isation policies could force companies or individuals to withdraw FX from the financial system or transfer assets abroad.”

In a final note, Peach warned: “The lira deposit protection scheme puts the government on the hook for a large bill in the event of lira weakness – the more the lira depreciates and the more interest rates fall, the greater the cost (the government has not put a number on the fiscal cost). And forcing banks to hold more bonds has the look and feel of financial repression by making it easier for the government to finance itself (possibly ahead of a pre-election splurge [with elections due by June at the latest]). This comes at the cost of crowding out credit to the private sector and a misallocation of resources.”

 

Table : Key Policy Measures in Turkey as Part of the “New Economic Model” (Dec. 2021 – Oct. 2022)
Date	Sector/Area	Description
Dec. 2021	Deposits	Introduction of a lira deposit protection scheme that pays a return equal to the greater of the interest rate on the deposit and the rate of depreciation of the exchange rate. Applies to time deposits with a maturity of 3-12 months.
Apr. 2022	Corporate earnings	Requirement for exporters to sell 40% (up from 25% in January) of their FX revenues to the CBRT in exchange for lira.
Apr. 2022	Reserve requirements	CBRT reduced the interest rate on lira-denominated required reserves to 0%.
Apr. 2022	Reserve requirements	CBRT imposed reserve requirement ratios on all lira-denominated bank loans (normally applied to a bank’s liabilities) except loans to SMEs, exporters and agriculture. The standard reserve requirement ratio is 10%, rising to 20% for high loan growth.
Jun. 2022	Bond requirements	CBRT requirement for a minimum of 45% of collateral in swap transactions to come from lira-denominated government bonds.
Jun. 2022	Reserve requirements	CBRT increased the standard reserve requirement ratio on all lira-denominated bank loans excluding loans to SMEs, exporters and agriculture from 10% in April to 20%.
Jun. 2022	Bond requirements	CBRT requirement for banks to hold bond securities equal to 3% of FX deposits on top of required reserves, rising to 10% for banks that cannot convert customers’ FX deposits to lira.
Jun. 2022	Bank lending	Banking regulator prohibited new lira-denominated loans to companies with more than TRY 15mn ($1mn) of FX cash and which represent >10% of total assets or annual revenues.
Jul. 2022	Bond requirements	CBRT requirement for a minimum of 50% (up from 45% in June) of collateral in swap transactions to come from lira-denominated government bonds.
Aug. 2022	Bond requirements	CBRT replaced the existing 20% reserve requirement ratio on lira-denominated loans from June with a 30% collateral requirement on government bonds.
Aug. 2022	Bank lending	CBRT requirement for banks to hold securities as collateral equal to 20% of commercial loans extended with an interest rate 1.4 times the CBRT reference rate, with the requirement rising to 90% of commercial loans with an interest rate more than 1.8 times the reference rate.
Aug. 2022	Deposits	CBRT raised the minimum percentage of customers’ FX deposits that banks need to convert to lira and raised required reserve ratios for FX from 5-10% to 10-20%.
Sep. 2022	Deposits	CBRT raised the commission on FX deposits.
Oct. 2022	Deposits	CBRT requirement for banks to allocate 5% (up from 3% in June) of bond securities against FX deposits on top of required reserves.
Source: Refinitiv, Bloomberg, CBRT, BDDK, Turkey Finance Ministry, Capital Economics