No one should be surprised by Turkey’s recent economic and financial woes. The country’s triple crisis (currency, banking and sovereign debt) has been unfolding for years. Whether this economic turmoil will incite political turmoil is now a widely debated question. Prolonged high inflation and widening deficits were stalking the Turkish economy even before the Covid-19 pandemic hit . For over a decade, inflation expectations have exceeded the 5 per cent target by more than half. And the Turkish lira has been depreciating against the US dollar since late 2017, with a 20 per cent decline in August 2018. Aggressive policy accommodation during the pandemic, an unsustainable policy mix that relied on excessive credit growth, and the sale of the central bank’s foreign exchange reserves to offset the impact of capital outflows generated further vulnerabilities. This led to a further 40 per cent loss in the lira’s value since last January. In November, President Recep Tayyip Erdogan appointed a new finance minister and central bank governor. Subsequently, the country’s monetary policy framework underwent a long-overdue normalisation and the lira regained 10 per cent of its lost value by the end of the year. Turkey has maintained a floating exchange rate since 2001. It adopted an inflation-targeting regime, under which policy rates should not be adjusted to engineer currency appreciation or depreciation. Financial markets are forward-looking and know that inflation can be managed only through credible monetary policy. So, why didn’t markets price in a sharp depreciation of the lira much earlier? The answer lies in the importance of US monetary policy spillovers for emerging markets. The abundant global dollar liquidity created by low US interest rates implied easy access to foreign exchange for emerging-market banks, including lower borrowing costs. With this in mind, Turkey’s slow-moving crisis can be divided into three phases. During the pre-Covid-19 phase, the lira was slowly depreciating as underlying structural problems went unaddressed. The second phase of the crisis began when the pandemic hit last March. Turkey initially responded with monetary and fiscal accommodation. But expansionary monetary policy quickly reached its limits. Why a ‘strong dollar’ mantra will not keep the US currency from sliding The decline in interest rates below the double-digit inflation rate triggered dollarisation, with domestic and foreign aversion to lira-denominated assets leading to sharper currency depreciation, which Turkey tried unsuccessfully to curb by selling roughly US$130 billion of FX reserves . A country that runs out of FX reserves can, in principle, borrow on international markets and continue intervening to manage its own currency’s volatility. In fact, in times of increased global uncertainty, it is cheaper to borrow in FX than in local currency. But Turkey did not necessarily benefit from lower borrowing costs. With FX reserves being sold through banks to tame depreciation, and households increasing their FX deposits in response to rising inflation, the FX mismatch on banks’ balance sheets grew quickly. Dollarisation gained traction as the pandemic continued, with residents’ FX deposits accelerating particularly rapidly in early August – thus increasing banks’ FX liabilities to domestic households. Turkey’s crisis shows a deeper disease – and Asia is infected Banks cannot engineer a balance between exchange rates and interest rates in a country with liberalised capital flows, where banks’ funding conditions are affected not only by the global financial environment but also by country risk. Using banks for this purpose, instead of implementing credible fiscal and monetary policies, destroys both internal and external economic balances. Now, the Turkish crisis is in its third phase. The central bank lifted its benchmark interest rate by 2 percentage points in September. But it did not complement its tightening cycle with another rate hike in October, instead hiking interest rates implicitly through liquidity operations. This reinforced the view that policymakers are unwilling or unable to address the most urgent challenges they face. The adverse market response triggered the events leading to the replacement of the economic team. The new central bank governor and finance minister have insisted that inflation targeting will be a priority for Turkey. Yet the country’s monetary policy will ultimately be influenced by Erdogan , who has often reiterated his belief that high interest rates cause inflation. What will happen once the financial markets stabilise? Will the central bank maintain its tighter stance, consistent with orthodox inflation targeting, or will it consider rate cuts in an attempt to “lower” inflation, following Erdogan’s suggestions? Investors are paying attention. If Turkey’s tighter policy stance proves to be a one-off attempt at stabilising the exchange rate, and the country cuts interest rates in the coming months in a bid to reduce the inflation rate, its slow-moving crisis will undoubtedly continue. Selva Demiralp, professor of economics and chair of economic research at Koç University, is director of the Koç University-TUSIAD economic research forum. Şebnem Kalemli-Özcan, a former senior policy adviser at the International Monetary Fund, is professor of economics at the University of Maryland, College Park. Copyright: Project Syndicate