Turkey's bid to join the European Union has been on ice for years, but the economic bloc's financial woes have made the country's currency something of an honorary member.
The lira hit a record low against the dollar on Monday. At mid-day Tuesday it strengthened, but with the U.S. currency buying about 1.84 liras, the Turkish currency has shed close to a third of its value in the past 10 months. Since the start of September, the lira has sunk almost 8 percent even as Turkey reported that gross domestic product jumped 8.8 percent year-on-year in the second quarter and exports soared 30 percent in August.
The lira's downward trajectory may not be over. Istanbul-based Global Securities this week said the lira's value may weaken to 1.90 to the dollar
The reasons behind the sinking Turkish lira range from the psychological to the real. But they almost all can be traced back to neighboring Greece, which is struggling to cope with a debt so massive that it threatens to undermine the economies and credit markets of its fellow EU members.
"If there is a crisis next door people get worried," Yarkin Cebeci, an economist who covers Turkey for JPMorgan Chase, told The Media Line. "But the more important issue is the liquidity squeeze in European banking sector. The Turkish economy needs capital inflows. The financing opportunities for Turkish banks and non-banks could dry up. That's the major concern."
Europe is already feeling the effect of a Greek-induced drying out.
The continent's banks have had trouble accessing short-term funding amid concerns about their exposure to Greek and other problematic debt, forcing the European Central Bank to serve as a lender of last resort. Analysts say that unless Greece's problems are addressed quickly, medium- and long-term credit could disappear as well.
Turkish banks have little or no exposure to Greek or other problematic debt, but the country has a massive current account deficit that has to be funded with debt inflows rather than foreign direct investment. That puts Turkey into a precarious position even as its economy is enjoying a boom that the rest of Europe can only envy.
The deficit in Turkey's current account, which measures the flow of money coming into and out of the country from trade and other activities, widened to a record $74.6 billion in the 12 months to July. That's equal to about 10 percent of GDP, a figure economists have warned for some time is not sustainable even without Europe's credit woes.
Turkish businesses could count on the $100 billion or so over foreign currency held in the country by domestic investors, but they have also grown nervous and aren't ready to lend it, said Ozgur Altug, chief economist at BGC Partners. Turkey's central bank has stepped in but even on days when it makes large amount of foreign currency available, it's not enough to make up for the loss, he said.
Europe's woes also threaten Turkey's export-oriented industry. Although Turkish Prime Minister Recep Tayyip Erdogan has worked hard to step up trade and business ties with the Middle East, Europe is still Turkey's biggest overseas market, accounting for 57 percent of total exports in the first five months of this year
The conventional wisdom in Turkey tends to discount the problem of the lira on the ground that it is suffering amid a global sell-down of emerging market currencies, with analysts saying that Turkey has performed no worse in recent weeks than the South African rand and Hungarian florint. But Altug said the lira started off from a lower base than the others, losing some 25 percent of its value between November 2010 and the start of August when worries about Greece emerged.
"The lira should have outperformed its peers. But this is not happening. We have outperformed peer currencies a little bit, but the fact is the Turkish lira continues to deprecate," he told The Media Line.
He said the difference between Turkey and its peers is the current account deficit and the central bank's policy of lowering interest rates in an effort to keep Turkish exporters competitive by effectively lowering their dollar costs.
Since the end of last year, the central bank has been lowering interest rates to discourage the flow of foreign "hot" foreign money into the country while it tries to contain consumer demand by forcing lenders to keep more of their funds on deposit with the central bank.
The policy has elicited a lot of criticism, not the least from the International Monetary Fund, which indicated earlier this month that the lira's depreciation had gone too far and urged the central bank to adjust its policies, including raising interest rates. The weakening lira is stoking inflation, with Turkey's consumer price index accelerated in August to 6.7 percent.
But it seems unlikely that Turkey will be able to avoid a sharp slowing of economic growth.
That could be good news for the country's current account deficit, which Standard & Poor's, the bond rating agency, said in a Sept. 20 report would narrow the current account deficit. That would reduce Turkey's appetite for foreign currency and encourage an appreciation of the lira.
But it could spell bad news for Erdogan, who rode to a third term in office on the back of the country's booming economy and is trying to parley the country's business prowess to turn Turkey into a regional power.
"You're seeing signs of significant slowdown in the economy. Domestic demand is slowing and there is not much to expect strong export performance," said Cebeci of JPMorgan Chase. "We see growth slowing down to 6.3 percent by the end of the year and below 3 percent in next year."
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