IslamicFinance.de

Dear Readers,

The dramatic fall of the Turkish lira leads to a lot of coverage in the international media. What are the underlying economic drivers of this fall in value?

All economies are suffering from too much debt on sovereign, corporate and consumer level due to the promotion of debt finance, by basle regulation and faulty tax incentives.

But: Turkey is special because its consumers are highly indebted buying a lot of consumerware on credit, and the corporates borrowed short term in foreign currencies way too much. The first contributes to a trade deficit and the second to vulnerability when the currency exchange rate of the Lira is dropping.

The corporate borrowing, is funded by so-called carry trades, where investors buy higher-yielding assets with funds borrowed in lower-interest-rate countries. This stabilises initially the Lira, but makes it vulnerable to withdrawal. Typically the desire to withdraw funds is calmed down by raising interest rates. Turkey was number one for this funding method and now is punished for taking such unreasonable risk. See an old article from 2016 about carry trade as investment opportunity:

https://www.bloomberg.com/news/articles/2016-05-02/turkey-s-lira-leads-c...

More countries are mentioned in the article, which are exposed to such carry trades, being India, Chile, Brazil etc. all affected, when this carry trade is being unwinded.

And an important background on corporate borrowing in Turkey is discussed here:

https://ftalphaville.ft.com/2018/08/06/1533528000000/Turkey-s-corporates...

It makes clear that the problem is not so much the absolute level of sovereign borrowing but the risk taken in foreign currency debt by the corporate sector. Debt to GDP for Turkey stands at a low 28.30% on tradingeconomics.com compared to e.g. Germany with 64.1%. Even with a lot of deficit spending, Turkey, as country, remains less indebted than most countries on the list. It is the private sector, which spends too much.

Nvertheless, once panic starts during unwinding all the carry trades other holders of Lira join in and will sell off at any price to get Dollars or Euros. New investors will eventually coming in, looking at the cheap asset prices, e.g. in properties in Turkey, where right now appartments can be bought as cheap as 30'000 USD. But till this funds flowing in, a panic can hurt the overall economy a lot, leading to a downturn/recession.

Lesson 1: The key problem with funding by using carry trades is the short duration of the financing. This increases vulnerability, while enabling long-term funding has to be a strategic priority by all parties involved, it is not easy to achieve.

Lesson 2: Proper incentives in banking regulation and taxation and a reasonable funding structure would make countries more resilient. A good first step would be to gradually withdraw from the tax deductiblity of interest, first exempting foreign currency debt, and then short-term debt to be a tax deductible expense thus leading to more stability in the economy and gradually preparing a level-playing field for equity finance.

Lesson 3: Political talk of the day is less important than structural issues, such as tax, regulation and attitude to debt. Politics is not the cause, but a trigger for an already injured currency. The currency drop was no surprise and caused by unsustainable short-term funding, just the timing has a political dimension. The error done was a decision taken by the private sector, which the politicians didn't stop.

Best regards,

Michael Gassner
www.islamicfinance.de