Can capital controls happen in Turkey?
Political rifts, President Recep Tayyip Erdoğan’s ambitions to consolidate power and the accompanying deterioration in the Turkish economy have manifested themselves in the growing budget and current account deficits, and double-digit inflation. These factors will be making the headlines in Turkey throughout 2018.
Economic stability has become a distant dream for many Turks, who had previously enjoyed a period of steady, strong growth in the economy, thanks to cheaply available external funding since the 2008 financial crisis.
Last week’s announcement of the November balance of payments deficit showed the degree to which Turkey is unable to attract quality foreign funding.
The deficit to GDP ratio, which increased to 5.5 percent, compares very unfavourably with the emerging-market average of 0.5 percent.
The fact that 60 percent of the deficit is being financed by portfolio investments -- hot money - means Turkey is highly prone to shifts in expectations. That is, there is a risk of severe volatility down the road due to the deterioration in the financial accounts as the Federal Reserve increases the pace of rate hikes and domestic politics in Turkey become more tense ahead of elections next year.
It would be naive to assume that the withdrawal of some $15 trillion of excess liquidity created by central banks in the past 10 years could work out smoothly, without shocks or accidents. The massive liquidity injections that cushioned the recession in advanced economies are now a threat to global financial markets with bond yields already edging up. While the central banks’ unwinding efforts are still gradual, a third year of rate hikes from the Fed combined with the ECB’s tightening is expected to create a bumpier ride from the second half of the year into 2019.
Among emerging markets, Turkey stands out with its fragile macro-economic indicators and serious dependence on external borrowing -- to the tune of $200 billion in 2018 -- to keep growth strong, and to control the currency and thus inflation. The changing tide in global financial markets and weak domestic policy guarantees trouble. Turkey is poised to face turmoil in its economy down the road.
The conclusion of the case in U.S. courts against Halkbank deputy CEO Mehmet Hakan Atilla – which concluded that Halkbank officials violated U.S. sanctions on Iran - might result in a fine on Halkbank by the U.S. Treasury. In the case that the AKP government refuses to pay, Turkey may face sanctions that would affect the whole banking system. The U.S. congress could also introduce sanctions to penalise Turkey for sealing a deal with state-run Russian arms companies to buy S-400 missiles, as both the exporter and producer of the system are blacklisted by the U.S. State Department.
As in the aftermath of the 2008 financial crisis, desperate times require desperate measures to keep economies rolling. This has been true both for advanced economies and emerging ones. These days, the changing tide in global financial markets will end the flow of easy money to emerging markets. The deterioration of Turkey’s relations with the Western world, the main financier of the economy, further complicates the situation.
If sanctions are imposed, if Turkey is announced as, let’s use the word - a rogue state that disregards international law or diplomacy - could Erdoğan go to extremes and impose a diluted form of capital controls to “save” the Turkish economy?
With a management style that explores the unexplored, Erdoğan and his AKP are always prepared to travel in new and unpredictable directions.
Could the Turkish administration become inspired by the European Commission? Or the Central Bank of Egypt? Not to mention the capital controls that the PBOC has imposed since the yuan's decline accelerated in 2015, measures that were only recently revamped.
Early in the summer of 2017, as part of an update of the Bank Recovery and Resolution Directive, the European Commission prepared new legislation to prevent bank runs, allowing EU governments to temporarily stop people withdrawing money from their accounts. Under the plan discussed by EU states, pay-outs could be suspended for five working days and a freeze could be extended to a maximum of 20 days in exceptional circumstances.
With inspiration from what happened to Banco Popular of Spain, the proposal got support from a number of governments. Opponents argued that the legislation could actually hasten deposit withdrawals at the slightest rumour of a bank being in trouble. Unable to cut the deadwood from the banking sector despite trillions of euros in new liquidity, the expected rise in interest rates was the main driving force for the EU Commission’s proposal.
Deposit freezes had become a new, palatable measure across the EU.
As for Egypt, the Central Bank of Egypt (CBE) put in place strict controls on the movement of foreign currency after the 2011 political uprising to limit capital flight. The controls initially helped keep Egypt’s currency stable. Yet, as time passed, the decline in foreign investment inflows and deposits from Egyptians abroad – given the impossibility of re-transferring the cash back outside the country without any restrictions - the Egyptian pound depreciated quickly. The scheme is now being abolished gradually under an ongoing International Monetary Fund programme.
Thanks to a clean-up during the 2001 economic meltdown, Turkish banks are nowhere near as troubled as their peers in the EU. Introducing a Latin American-style freeze on bank deposits, or measures derived from countries such as Egypt and Greece, has never been attempted in Turkey. The government even refrained from such steps between 1999 and 2001, when the banking sector fell into crisis and was rescued with some $60 billion in funding.
Individuals and businesses can freely hold foreign currency in Turkey. Bank accounts denominated in foreign currency total some $160 billion. However, dollarisation has always been a problem that impacts monetary policy. As the lira started to weaken from mid-2013, the value of dollar deposits crept up to 41 percent of total deposits from lows of 30 percent seen in 2012, when capital inflows were the main cause of concern.
According to the IMF, policymakers in emerging market economies have five potential tools to manage capital flows: monetary policy, fiscal policy, exchange rate policy, macro-prudential measures, and capital controls. After efforts on the monetary, fiscal and exchange rate fronts, governments could as well go for capital controls in their most desperate hour.
With the possibility of sanctions against Turkish banks, what would stop the AKP government from issuing a new presidential decree to keep foreign exchange reserves intact? What would prevent a new decree under emergency rule banning FX deposit holders from withdrawing hard currency from their accounts? Any FX inflows and outflows needed for external trade purposes could be kept exempt from the scheme, meaning capital flows would “not be restricted”. While locals would be banned from withdrawing hard currency, they could be allowed to withdraw the corresponding lira sum, as a substitute should they need the cash.
Would that be considered a form of “moratorium”? Perhaps yes, though not in the typical sense.
Such a situation is of course hypothetical.
While controlling capital inflows was seen as a legitimate tool in preventing overheating in emerging economies since the 2008 crisis, countries that impose controls on capital outflows are still seen as undesirable by the liberal financial system.
Moreover, any capital controls imposed by Turkey would likely bring so much pain in the years to come that they wouldn’t be worth introducing as a short-term measure. Even mentioning such an idea would likely make retail banking clients more jumpy, render banks more fragile and thus reflect on the value of the Turkish lira.
Yet, Turkey is extending the period of emergency rule, presidential elections are approaching - a must-win for Erdoğan - economic fundamentals are deteriorating and relations with western allies are at a new low…
It might well be food for thought for the government...