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Solving Turkey's problems will require more than just raising interest rates

Investors and financial analysts are urging Turkey to make changes to its central bank policy, namely increasing interest rates. But that may not make much difference.

The lira has plummeted (TRY=X) over the past few days, sinking 33% in just three days and down as much as 40% year to date. The recent history of another troubled emerging market suggests conventional measures won’t stop the bloodletting.

“There are only three options to halt the freefall of the Turkish lira,” tweeted Dani Rodrik, an economist at Harvard University. “1. Sell dollars at the expense of using up the central bank’s reserves. 2. Announce a serious rate hike. 3. Capital controls. Choose your poison.”

Those may be the only options, but even if Turkish President Recep Tayyip Erdogan were to comply with market demand for action, Argentina’s ongoing currency crisis is evidence that it may not work. Argentine President Mauricio Macri has been working to stem the peso’s (ARS=X) slide and has taken extreme measures.

Argentina’s central bank raised overnight interest rates to 40%, hiking them by more than 10% in just a week. For comparison, U.S. benchmark interest rates are currently 1.875% and Turkish rates are currently 17.75%. Turkey’s central bank voted against raising interest rates at its latest policy meetings despite inflation creeping up to 16%.

Turkey’s President Erdogan

The country took an emergency $50 billion loan from the International Monetary Fund earlier this year. That came at tremendous political cost to Macri as a majority of Argentines view the IMF as an insidious force that was behind the country’s devastating recession at the turn of the century. Former Presidents Nestor Kirchner and Cristina Fernandez de Kirchner, who presided over the country for 12 years, often blamed the IMF and “vulture” investors for the country’s booming inflation and economic collapse.

Many believe Erdogan is behind the decision not to raise rates, as he said during his campaign for re-election “interest rates are the mother and father of all evil.”

“Our view is that they probably should be raising interest rates and … the claim that Erdogan is making that he doesn’t want to go down that path will remain the elephant in the room,” Eric Robertsen, head of global macro strategy and FX research at Aberdeen Standard, said on CNBC’s “Squawk Box” program. “This will be, in our opinion, a key step to watch.”

The market has faith in Turkey’s central bank governor, Murat Cetinkaya, but he’s been effectively defanged by Erdogan. In a July decree following his controversial election victory, Erdogan removed thousands of government workers from their roles and fired his Treasury and Finance ministers to make his son-in-law the new minister of both. Erdogan also granted himself authority to appoint the central bank governor and his deputies.

The previous economic team was one markets had confidence in and the new team of loyalists has created the impression that Erdogan alone now controls fiscal and monetary policy in the country and is refusing to raise interest rates.

But raising rates hasn’t worked out for Argentina. Since hiking its overnight rate to 40% in May, the peso’s decline has worsened. Having hit an all-time low of 24 pesos per dollar previously, the peso is now trading near 30 per dollar. The currency had been the world’s worst performer until the Turkish lira overtook that dubious designation.

The value of the dollar against the Turkish lira so far in 2018. The dollar’s value against the lira rose to a record high last week against the lira and has risen even further since.

Inflation also has been stubborn despite furious rate hikes and Macri’s elimination of some subsidies for the poor and tightening of government spending.

While analysts have been loath to use the word contagion to describe the situation in emerging markets, the Russian rouble, South African rand, Brazilian real and a host of other currencies around the globe have seen selling as the lira crisis has pushed forward.

“What you’re looking at is a good, old-school EM currency crisis,” said Karl Schamotta, director of global product and market strategy at Cambridge Global Payments.

With Erdogan seemingly sticking to his guns and the dollar continuing to strengthen, there appears no end in sight to Turkey’s troubles and perhaps those in other emerging markets.

See also:

Wall Street managers have cost Americans more than $600 billion over the past decade

It’s the end of the world as we know it, and investors feel bullish

The dollar’s status as the world’s funding currency is in question

Why Trump’s trade war hasn’t tanked the market or the economy yet

Dion Rabouin is a global markets reporter for Yahoo Finance. Follow him on Twitter: @DionRabouin.

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