Blog entry by Karim Mansour
Inflation, Interest Rates & Forex
Relevant to the following CISI qualifications: IISI, Securities, Global Securities, ICWIM, ICAWM.
The inter-relationship between inflation, interest rates and foreign exchange rates has always been a popular area in CISI exams – with varying difficulty across different levels.
The recent turmoil in the Turkish Lira provides an excellent case study that would help students understand how the three pillars of monetary policy influence each other.
Before we begin, it is important to seperate the factors that caused the crisis between economical factors (inflation, interest, fx) and non-economical factors (psychological and religious).
Exports and GDP
Since July last year, the Turkish Lira has lost 35% of its value against the US dollar. This was mainly attributed to Trump’s tariffs on aluminium and steel which were imposed as a political retaliation for the imprisonment of an American pastor.
Tariffs on Turkish products will cause American importers to import less from Turkey and source their aluminium and steel from somewhere else. This means lesser exports from Turkey to the USA. If you’ve taken any CISI securities qualification, you’ll know that any adverse changes in exports have a direct effect on a country’s economy (remember: GDP = consumer spending + government spending + investments + exports – imports).
CISI exam point: negative movements in exports = negative effects on GDP = negative effects on currency
Interest rates and Inflation
Turkey’s inflation rates currently stand at an astonishing 15%. For comparison, in the USA, UK and the UAE inflation rates hover around 2%. Turkey has continuously used credit and its budget to stimulate its economy. This meant deficits in its current account and public-sector budget. These deficits were covered through foreign direct investments (FDI) and external borrowing (bond issuance). The yields on Turkish 1-year to 10-year government bonds range between 20% and 25%. Recent growth in income and GDP however was not adequate enough to cover the debt burden.
CISI exam points: Deficit in current account means imports are higher than exports. Governments cover deficits by borrowing – usually through the issuance of bonds.
With inflation at such high levels, investors and creditors expected the Turkish central bank to increase interest rates which are already high at 17.75%. Contrary to expectations, the central bank held interest rates at that level. This raised concern among investors who started to believe that the central bank is not serious about controlling inflation and stabilising the currency. These concerns grew when Erdogan appointed his son-in-law to run the Treasury and Finance Ministry.
CISI exam points: When inflation is high, central banks are expected to interfere and raise interest rates. This will cause borrowing to drop. Consequently, inflation will drop too.
As a conservative Muslim, Erdogan has continuously expressed his loathing for interest rates. On multiple occasions, he’s been quoted saying:
“If my people say continue on this path in the elections, I say I will emerge with victory in the fight against this curse of interest rates.”
“Because my belief is: interest rates are the mother and father of all evil.”
Islam considers charging interest on debts as usury, or “riba”, which is therefore prohibited. Therefore, Erdogan’s description of interest rates is literal and not figurative. Investors believe that Erdogan’s lack of understanding of how interest rates influence currency levels stems from his deep hatred for interest – which is not expected to change any time soon.
This article was originally published on Tadawul Academy’s website https://www.tadawul.academy/2018/08/16/cisi-exam-articles-inflation-interest-rates-forex/