Now, however, it looks like Turkey is in even more trouble. Just today its currency depreciated sharply, by about 15% (see chart below). It’s down by more than 20% from a week ago and more than 80% from a year earlier.
The big worry here is that interest rates are already really high by international standards, well exceeding 10% and so is inflation. It will require really drastic policy change now to halt this crisis, and I’m not very confident that the Erdogan regime will do what would be required.
The Central Bank would need to hike interest rates by several percentage points to stop further depreciation and the government would have to commit to consolidate fiscal expenditures in the years to come. As both measures combined would probably cause a relatively severe contraction in output, I am far from convinced that Erodgan’s government will actually come through and do what is required.
As a result, one can probably expect a further decline in the currency in the weeks to come, triggering a potential stock market crash as well. That is because the Turkish corporate sector has a large part of its debt denominated in foreign currency (dollars and euros). Given the large depreciation over the last few days, the value of the debt has ballooned now and Turkish corporations will have increasing difficulty servicing them he foreign currency denominated debt outstanding. But he way, this entire dynamic is classic third generation currency crisis model as summarized by Krugman, and very similar to what South East Asia experiences in the late 1990s. Saying that all of this will be over in a couple of days is probably betting on the wrong horse. Expect the Turkish economy to undergo a painful adjustment in the next year(s) to come.
As a side note, some observers are worried about potential contagion effects as it is mostly Southern European banks that seem to hold Turkish debt (France, Italy, and Spain). While this is certainly a possibility, it is rather unlikely if the ECB exerts its function of life lender of last resort and provides enough liquidity to the banking sector should problems arise.