Turkey took a few steps back from the brink last week. But the worst may still be yet to come.
Turkey's crisis isn't over yet — it's just taking a breather.
After dropping to a record low of 7.24 lira per U.S. dollar, Turkey's currency rebounded on Friday morning to 5.77 per dollar. In fact, the lira was the best performing currency on Earth last week — and it wasn't even close.
A big factor was a conference call Turkish Finance Minister Berat Albayra held with thousands of international investors on Thursday. "He said all the right things," Sailesh Lad, an official at AXA Investment Managers, told Reuters. "But it's one thing saying them and another thing doing them."
Investors were largely heartened by Albayra's promise that Turkey won't employ capital controls to limit the amount of foreign cash coming into or out of Turkey. That "was the biggest issue for investors" said Abishek Kumar of State Street. "I think a lot of the market liked hearing that," Lad added.
Unfortunately, Albayra's commitment to eschew capital controls suggests Turkey's response will prize the needs of international capital over the economic livelihoods of its own citizens. And that suggests that Turkey's crisis could just be getting started.
Turkey's crisis has played out in pretty standard fashion. The country opened itself to international financial markets, allowing foreign capital to pour in. But it also didn't have the deep institutional resources to respond when something went wrong. In this case, it was creeping inflation and interest rates that now stand at 16 percent and 17.75 percent, respectively. Then a trade spat with the United States went south fast. All that sent foreign investors into a panic, and they pulled their money from the country just as fast as they dumped it in.
That sent Turkey's currency plunging in value. Many Turkish businesses and banks now owe vast amounts of debt denominated in foreign currencies. The lira's drop has made those debts much harder to pay off, and corporate defaults threaten to rip through Turkey's economy, and possibly spread contagion internationally.
One way to dampen a crisis like this is to employ capital controls, which prevent exactly these sorts of destabilizing hot money flows into and out of developing nations. While capital controls can limit an economy's growth, they also protect an economy from the wild swings that international investment can bring.
The titans of international finance generally hate capital controls, because they prevent investors from shopping their money around the world for the most profitable opportunity. The U.S. government and the International Monetary Fund (IMF) have spent the last few decades successfully leaning on a lot of countries to scuttle their capital controls. Turkey is just the latest emerging economy to suffer this sort of crisis as a result.
The investor class also has its preferred alternative playbook: Pressure the government to slash spending, hike interest rates to combat inflation, and take a bailout loan from the IMF to hold over the debt obligations. The purpose, stated bluntly, is to drive a country into a deep enough recession, and drive its currency so low, that it flips into trade surplus. (Turkey is currently dealing with a significant trade deficit.)
Why is this desirable? Theoretically, because it will bring in the foreign currency needed to pay off the foreign-denominated debts, and eventually the way for the economy to right itself. No one likes to characterize the policy program in this manner, of course. But that's basically the point. And investors from Germany to Norway are already insisting Turkey do exactly this.
There are problems, however. First off, Turkey's government has actually run pretty low deficits for years now.
Furthermore, inflation isn't being driven by too much aggregate demand in Turkey. More likely, what's causing inflation is the lira's fall combined with the fact that large portions of Turkey's daily economic activity is denominated in other currencies, especially U.S. dollars. Almost all its energy supplies come from foreign-denominated imports, for example. As the lira gets weaker, the portions of Turkey's economy that trade in dollars get even more expensive, driving up Turkey's overall price level.
If that's the case, higher interest rates could paradoxically make inflation worse, not better. And wreck Turkey's economy besides.
So what else could Recep Tayyip Erdoğan and his government try? How about letting the lira fall so they can address the trade imbalance. And weathering defaults and debt writedowns to clear foreign currencies out of Turkey's economic system. Then they could actually ramp deficit spending way up — with a mix of stimulus, welfare expansion, and industrial policy — and push interest rates way down to rebuild jobs, wages, and investment, and counteract the economic contraction.
Reimposing capital controls would be crucial to that strategy. If the government wants to flood Turkey's system with new supplies of the lira, it needs to make sure the country's own wealthy elites don't just suck those supplies right back out of Turkey again and sock them away in foreign banks.
Unfortunately for Turkey's citizens, Erdoğan appears willing to avoid capital controls and cut government spending. His government has also provided liquidity to domestic banks and backed off some regulatory requirements. But so far they're refusing any bailout from the IMF. (Turkey's government did take a $15 billion loan from Qatar, but it's probably far too small.) And Erdoğan is dead set against interest rate hikes.
Turkey's president talks a big game about opposing the predations of financial elites. But he may not be willing to actually turn on them with aggressive economic policy. Instead, Erdoğan will likely continue coasting on authoritarianism and demagoguery.
It's telling how quickly Turkey's government has already caved on capital controls: Ultimately, they'll probably conclude that knuckling under to investor class demands is the easier way out.