Today’s video is sponsored by the Daily Upside, a totally free, high quality daily business and finance newsletter. Visit the link in the description to learn more. President Erdogan’s government announced extraordinary measures earlier this week to boost the Turkish lira, including a new savings product designed to protect savings from currency fluctuations. These savings schemes are set to be rolled out in a few days and we don’t yet know how much takeup there will be or what the impact will be on the public finances in Turkey. The Turkish Lira rose more than 40 per cent against the dollar after the announcement and has been rallying since. This is a dramatic change in direction after the exchange rate had hit a record low the previous day. Monday was the most volatile day of trading for the lira since the new Turkish lira was introduced. The idea of this savings product is that the Turkish Treasury will make up for losses incurred by savers if the lira’s falls by more than the central banks interest rate against the dollar over the life of these savings plans. This investment is available to individuals, but not to businesses and the accounts will have maturities between three and twelve months. The minimum interest rate will be the central bank’s benchmark rate and no withholding tax will be applied. So, if banks pay 14% for one-year lira deposits but the currency depreciates by more than that against the dollar in the same period, the Treasury – which really means - the taxpayer -- would pay deposit-holders the difference. Let’s take a look at how the scheme works and what it might mean for the Turkish Economy. So, Turkish savers under this scheme are allowed to lock their money up for a minimum of three months or a maximum of 12 months. If you lock your money up for 12 months, you will receive an interest rate of 14 per cent along with the new government-backed exchange rate guarantee. In a years time if the lira has stood steady or advanced against the dollar, savers will receive the 14% interest rate on their savings. If the lira has fallen by more than 14%, the Turkish government will compensate savers for the difference, protecting them against the decline of the currency. The idea is that it will be as if they had converted their savings into US dollars. There are early withdrawal penalties, where if you take your money out before the agreed upon date you’ll get no interest, and you’ll get the lowest exchange rate of either the rate on the day you put your money in, or the rate on the day of the early withdrawal. This scheme is only available to individuals in Turkey, not businesses. When announcing the deal, Erdogan said “From now on, none of our citizens will need to switch their deposits from the Turkish lira to foreign currencies because of their concerns that the exchange rate fluctuations might wipe out gains from interest payments”. The idea of this product is to incentivize Turkish people to keep their money in the lira, instead of either exchanging it for dollars (which would be bad for the exchange rate) or spending it (which might be inflationary). Traditionally the way monetary policy works is that when inflation is high and a currency is falling in value, the central bank raises interest rates. This high interest rate incentives people to hold your currency – they move their money into the currency in order to earn the interest. The higher return on savings equally incentives people to save rather than spend - reducing inflation. Very low interest rates – rates below the rate of inflation encourage people to borrow and spend. Now, there are a few ways we can think about this savings product, one is as a savings account with a variable interest rate tied to “however much the currency falls.” The Turkish government is probably hoping that this will stop Turkish people from selling the lira and then they won’t actually have to pay out much money. It is, to a certain extent, a way of raising interest rates without actually saying that you are raising interest rates – it is a bit funny because it raises rates only for certain savers, while keeping rates low for borrowers. Another way of looking at this product is as a sort of currency peg, but (once again) only for certain retail accounts. This is a little bit confusing, as usually a currency peg applies to the whole currency, not just certain accounts. The way this works is that the central bank will print more lira, the more the lira falls. Which doesn’t necessarily sound like the best idea. 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Sign up using the link in the description below. [End of Sponsored Content] OK, so why is this happening in Turkey right now? Well there are a few reasons. The first thing I should point out is that there are no capital controls in Turkey. In places like China or India, the government can get away with keeping interest rates artificially low, because they have capital controls in place preventing people from taking their money out of the country – or out of the currency. Local citizens are trapped to a certain extent. The Turkish government can’t do this, because they have a negative current account and a positive capital account. What this means is that Turkey imports more than they export, and they finance this by bringing in funds from abroad. If Turkey were to put capital controls in place, no foreign exchange would come into the country. This is because investors would be aware that if they move money in, they couldn’t get it back out. If money stopped coming into Turkey, the country could no longer import goods that they need like oil and gas for example. Now, this isn’t a problem for countries like China who are in a very fortunate position where not only do they export more than they import, but also foreign investors keep pouring money into the country. You can only get away with capital controls if you are an export driven economy or if you are a wealthy country like Switzerland where there is enough money to have investments outside the country and there is no need to have capital flow in. I should point out that there is nothing wrong – in general – with Turkey’s situation of having a negative current account and a positive capital account, you see it very frequently in growing economies where they need capital to come in and fuel growth. So, Turkey doesn’t have capital controls, but due to the extreme inflation, the Turkish economy has become extremely dollarized. Dollarization is the term for when the U.S. dollar is used in addition to or instead of the domestic currency of a country. It usually happens when a country's currency loses its usefulness as a medium of exchange, due to hyperinflation or instability. In Turkey, it is easy to open a US dollar account at your local bank, and around 60% of the banking deposits in Turkey are in US dollars rather than in Turkish lira, additionally Turks can have accounts denominated in euros and precious metals. People keep their savings in dollars for stability and most of those dollars then stay within the banking system in Turkey. Now, some wealthy people in Turkey might keep their dollars offshore, (we’ll say at Deutsche Bank in Frankfurt for example), but that would be a small minority. When Turkish people borrow money, they will often borrow it in Turkish lira, and might use that to buy a house, a car, or even valuables like gold. Then, if the currency that they have borrowed depreciates, they benefit from that depreciation. When you put all of this together, it means that a lot of middle-class Turkish people – or people with savings and the ability to borrow are essentially short the Turkish Lira. Now, it doesn’t appear that a lot of analysis went into this savings product, it was probably quickly put together last week when the currency was in freefall and the Turkish stock market was collapsing, but it would appear that the idea is to convince Turkish people to exchange their dollars for Turkish Lira. If savers take money out of their dollar denominated accounts and put them in these savings accounts, they are basically selling dollars to the Turkish government in exchange for a synthetic dollar – which is what these accounts amount to. Along with the announcement of the new savings accounts came a Television advert where a well-known Turkish actor walks a friend through a museum, telling him that the nations flag, the national language and the parliament represent the country’s pride, and that “the Turkish lira is our power”. The goal is to persuade the Turkish people to turn their backs on dollars and gold and put their savings in lira. There are a few effects that these accounts might have on the Turkish economy. Despite what the President says, foreign speculators are generally not short the Turkish lira – one reason is that it is just much too expensive to borrow, overnight borrow rates are as high as 300% annualized. In fact, when you speak to foreign investors, most have no position at all in Turkey, and most of the banks no longer even produce research on Turkey, as they say that there is no investor interest. The problem is not foreign speculators, it is that the people of Turkey have simply lost faith in the lira as a store of value, because it depreciates so quickly. Now, given that inflation is expected to be at over 30 per cent in the months ahead, Turks with access to loans at rates close to the central bank’s policy rate of 14 per cent still might decide to borrow money to buy real assets or other currencies. This would be a continuation of the recent trend for Turks to take advantage of cheap loans to buy other assets, including houses, cars, gold and foreign exchange that would be expected to go up with inflation. If inflation is high, they win. The goal of this savings product appears to be - to convince Turkish people to give up their dollars in exchange for Turkish Lira and a guarantee. So, then we have to ask whether the Turkish people will want to do this or not. If they already own dollars, there is not much of an advantage of tying up your money like this to get the return you get from owning dollars. One of the comments on my last piece from a Turkish viewer said that the reason Turks prefer foreign currency to Lira is that they don’t trust the government’s economic policies. The viewer asked, “Why would you hold Erdogan dollars when you can hold real dollars?” If people do put a lot of money into this product, it then converts inflation risk into credit risk for the country. If the Turkish Lira depreciates, the government then has to issue more lira to pay it out to savers. The government has taken the exchange rate risk onto its balance sheet with this savings product. Up until now the lira depreciating, just caused inflation, but it didn’t harm the countries balance sheet, and it inflates away local currency debt, but this savings product almost behaves like foreign currency debt on the countries balance sheet. If the lira falls in value against the dollar the government owes more and more money. If you look at Turkish bond yields, you can see the credit spreads widening, this is because, up until now if the currency fell in value, the only risk for the country was the existing dollar debt – which was not too big – and this is something that is a big positive for Turkey. The more of this product Turkish people buy, the more dollar debt the country finds itself in. Another problem with this exchange-rate-indexed interest rate is that the wealthier an individual is, the more they can participate, and the Turkish taxpayer then find themselves financing the wealthiest people who can afford to put the most money in. So why did the lira jump so much when this savings product was announced? Well, one reason is that this product can be viewed as being an interest rate hike that is not called an interest rate hike, but another reason is that the Turkish central bank heavily intervened in the foreign exchange market in order to make it look like the announcement was having more of an affect than it was really having. Turkey’s foreign currency reserves fell by around six billion dollars in the first two days of the week. The Turkish central bank didn’t announce any official interventions. But the disappearance of its foreign exchange assets suggests that this played a significant role in the lira’s recovery. It would appear that Turkey has spent around 25 billion dollars in the last month trying to prop up the currency, and the central bank may be entirely out of foreign reserves at this point. As I said in my last piece, Turkey actually has a pretty good economy, it is well diversified, with manufacturing, tourism, trade and services. It is close to Europe, its biggest trade partner and there are a lot of good companies in the country. There is a young educated workforce and levels of household debt are quite low. This is a much better situation than countries like Argentina and Lebanon who have huge foreign debts to deal with. How things work out going forward will be heavily influenced by developments in the broader global economy. It was always going to be difficult for countries with more fragile economies like Turkey when rates started rising in the rest of the world, as those higher rates start to attract capital back home. If global rates were to stay low longer than expected, that could help Turkey as their interest rate policy would not look as bad. Don’t forget to check out our sponsor The Daily Upside, by clicking on the link in the description. It’s a great newsletter that I can firmly recommend. If you enjoyed this video, you should watch this one next. Have a great day and talk to you again soon. Bye.