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Analysts at Natixis look at the emblematic example of Turkey: Turkey’s national savings rate is insufficient to finance a normal level of investment, leading to a chronic external deficit and to the accumulation of external debt. As long as foreign investors (whether financial or corporate investors) have confidence in the country, there is no problem, as capital inflows will cover the savings shortfall but when confidence disappears, which happened in Turkey from 2014 and even more so from 2016, a dangerous vicious circle is triggered.

Key quotes

“The vicious circle results from the following cause-and-effect mechanism: When confidence disappears, problems financing the external deficit lead to exchange rate depreciation; the exchange rate depreciation leads to imported inflation and drives up interest rates; the imported inflation (deterioration in the terms of trade) weakens wage earners’ purchasing power and consumption; the higher interest rates weaken investment. This leads to a fall in growth and in potential growth and drives up unemployment.”

“The weakening of activity led to a strong economic policy response in Turkey: highly expansionary fiscal policy; an expansionary monetary policy, with interest rates that may be high but are constantly lower than inflation and, as a result, rapid credit growth. At first, this expansionary economic policy boosted growth, but then it exacerbated the crisis: the fiscal deficit amplified the savings shortfall and the external deficit; below-inflation interest rates amplified capital outflows and the exchange rate depreciation.”