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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. [Sponsored Content]Now, Before we discuss
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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.