Turkey’s Slow-Motion Economic Crisis

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 normalization (with a cumulative rate hike of 675 basis points in two months), and the lira regained 10% of its lost value by the end of the year.

Turkey has maintained a floating exchange rate since 2001, when banking, sovereign debt, and balance-of-payments crises forced it to abandon the lira's peg from a currency basket comprising the dollar and the euro.

Turkey adopted an inflation-targeting regime, under which policy rates should not be adjusted to engineer currency appreciation or depreciation, or in response to external shocks - such as COVID-19 - that lead to capital outflows.

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 FX 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 phase, the lira was slowly depreciating as underlying structural problems went unaddressed and inflation targeting was not a high priority. Turkish banks' ability to borrow easily in international markets precluded an even sharper currency depreciation.

The second phase of the crisis began when the pandemic hit in March this year. Turkey (like other countries) initially responded with monetary and fiscal accommodation. But expansionary...