Modeling 2018 currency crisis of Turkey: A balance of payments approach

The episodes of excessive depreciation of Turkish Lira and the currency crisis in 2018 have revealed increased vulnerabilities of Turkish Financial Markets to external shocks in recent years. A new modeling framework that allows integration of flow of funds recorded in balance of payments has been developed. The model not only successfully explains short-term dynamics of exchange rates, it also shows how episodes of excessive depreciation can be linked to external factors. Our results show that reliance on hot money flows, after quantitative easing policies by the major central banks in 2011 has contributed to the build-up of stocks of FX liabilities, which are subject to reversals and sudden stops in the short run. The results reveal how changes in Fed Rate or some other event of international significance may spur FX outflows from these stocks that can cause an excessive loss in the value of Turkish Lira. Simulation results of several scenarios have also shown that the Central Bank of Turkey may counter the reversals by raising its policy rates. However, this can at times be pro-cyclical and may contribute to macroeconomic instability. The preliminary results which are presented in this paper as a case study of Turkey may also have policy significance for the central banks in other emerging markets.