Will Turkey introduce capital controls?

The risk of capital controls looms in Turkey as the government struggles to contain a crisis that sank the lira in the currency market and increased pressure on public and private institutions to meet their external financing obligations.

The lira fell to a new low against the US dollar, hitting 7.01 in the currency market on August 13, from 3.8 at the end of 2017. Relations with the US also soured after a diplomatic stalemate over US pastor Andrew Brunson – who is in Turkish custody – prompted the White House to double tariffs on Turkish steel and aluminium. Mr Brunson has been held since October 2016 on charges of allegedly helping followers of  Fethullah Gülen, the exiled cleric the government accuses of orchestrating Turkey’s failed coup of July 2016.

The hands of the central bank now appear tied. President Recep Tayyip Erdoğan labelled high interest rates “the mother of all evil” during his presidential campaign, and made a more accommodative monetary policy a key pledge. While Mr Erdoğan’s promise may pleased the electorate (he was reelected with 52.6% of the votes in the first round of the June 24 poll), it further dented investors’ confidence, as the independence of the central bank now hangs in the balance.

“Tightening [interest rates] would be a huge policy u-turn and arguably dent Mr Erdoğan’s credibility. This suggests capital controls are the next step if other measures fail, which would dent investor confidence even further,” analysts at Exotix Capital wrote on August 14.

As Mr Erdoğan called on citizens to exchange the dollars kept “under your pillow”, while putting under investigation 346 social media accounts for allegedly playing a role in the demise of the lira, banking watchdog BDDK announced on August 13 that it would limit Turkish banks’ swap, spot and forward transactions with foreign investors to 50% of a bank’s equity. Private banks are already adjusting, with Garanti Bank, the country’s second largest financial institution, limiting certain foreign exchange operations on the grounds of excessive volatility in the currency market.  

“I think at this point, capital controls would be the best solution to contain the crisis,” Thu Lan Nguyen, FX strategist at Commerzbank, told Bloomberg on August 13, arguing that even if the central bank had the space to hike rates, it would not necessarily be able to shore up the weakening lira.

Analysts at Jeffries agreed. “The longer the central bank desists from hiking rates, the more likely some kind of capital controls will be adopted,” they wrote on August 14.

It remains to be seen whether Turkey has the room to absorb the foreign investment setback that would inevitably follow the introduction of capital controls. The country relies heavily on foreign capital to finance a widening current account deficit, and has already faced a steep slump in FDI in the past couple of years. Headline FDI fell to $2.8bn in the first six months of the year, from $4.2bn a year earlier, according to central bank figures.  

“FDI is forecast to remain around 1% of GDP, meaning that the deficit will be largely debt-financed,” credit rating agency Fitch wrote in July, when it downgraded the country’s sovereign credit rating from BB+ to BB with a negative outlook.

With Mr Erdoğan having been vocally opposed in the past to either an interest rate hike or an IMF bailout, the options are limited. Capital controls would save the day and prop up the lira in the short term, but would likely end the country’s long-standing tenure as one of Europe’s most attractive recipients of foreign investment.