Emerging-market currencies: inflation, capital flows and the Turkish lira as a case study

What you will learn

• Why emerging-market currencies move more and trend longer than major currencies.
• How to calculate a real interest rate and a break-even depreciation for a high-yield currency.
• Which balance-of-payments indicators show vulnerability.
• What the Turkish lira's recent history teaches about policy credibility.

Explanation

An emerging-market (EM) currency belongs to an economy that is growing and integrating into world markets but has less deep financial markets than the large developed economies. Examples include the Turkish lira (TRY), South African rand (ZAR), Mexican peso (MXN) and Brazilian real (BRL). Their spreads are wider, liquidity is lower outside local hours, and moves of several percent in a day are possible. The basic link between inflation differences and exchange rates (purchasing power parity) was covered earlier in this course; here we apply it to EM risk.

Real interest rate

The nominal interest rate is the stated rate. The real interest rate is the rate after inflation: real rate = (1 + nominal rate) ÷ (1 + inflation rate) − 1. A currency with a 40% policy rate and 30% inflation offers a real rate of 1.40 ÷ 1.30 − 1 = +7.7%. A currency with 25% rates and 35% inflation offers about −7.4%: savers lose purchasing power, which encourages them to move money into foreign currency.

Capital flows

EM currencies depend heavily on foreign money. Key terms:

• Current account: trade in goods and services plus income flows. A deficit means the country must attract foreign capital every year to pay for it.
• Portfolio flows ("hot money"): foreign purchases of local bonds and shares. They can leave within days when global risk appetite falls or US interest rates rise.
• Foreign-currency debt: loans in US dollars or euros. When the local currency falls, these debts become more expensive to repay, which can cause further selling.
• FX reserves: the central bank's stock of foreign currency. Low or falling reserves (especially net of short-term obligations) limit its ability to defend the currency.

Case study: the Turkish lira

Turkey shows how policy credibility affects a currency. In August 2018 the lira suffered a sharp sell-off amid high inflation, a large current account deficit and political tension. In late 2021 the central bank cut its policy rate several times while inflation was rising, and the lira lost a large part of its value within weeks. Official annual consumer price inflation peaked at about 85% in October 2022. From June 2023 the central bank changed course and raised the policy rate in steps, from 8.5% to 15% in June 2023 and eventually to 50% in March 2024. Later decisions and the current inflation rate change regularly; check the central bank of Turkey (CBRT) for current figures.

The lessons are general: negative real rates, a current account deficit and doubts about central bank independence together created long, persistent depreciation. A high nominal rate alone did not protect holders of the currency while real rates stayed negative.

Worked example

Hypothetical example: a euro investor converts €10,000 into a high-yield currency at an assumed rate of 30 units per euro and earns an assumed 40% interest for one year. Spreads, fees, taxes and swap costs are excluded.

1. Local amount: €10,000 × 30 = 300,000 units.
2. After one year: 300,000 × 1.40 = 420,000 units.
3. Scenario A, currency weakens to 39 per euro: 420,000 ÷ 39 = €10,769, a gain of about 7.7%.
4. Scenario B, currency weakens to 45 per euro: 420,000 ÷ 45 = €9,333, a loss of about 6.7%.
5. Break-even rate: 30 × 1.40 = 42 per euro. In euro terms the currency may lose 1 − 1 ÷ 1.40 = 28.6% of its value before the interest is fully eaten up.

The decision is not "40% is a lot". The question is whether a loss of more than 28.6% in a year is plausible. For a currency with negative real rates and outflows, it can be.

Common mistake

Practice activity

A hypothetical EM currency has a policy rate of 25% and inflation of 35%. The current rate is 20 units per euro. Calculate (a) the real interest rate, (b) the break-even rate after one year, and (c) the maximum depreciation in euro terms before the interest is eaten up. Then list two indicators you would check next.

Key takeaways

• EM currencies have wider spreads, lower liquidity and larger, longer trends than major currencies.
• Always convert a nominal rate into a real rate and a break-even depreciation.
• Current account deficits, hot-money dependence, dollar debt and low reserves increase vulnerability.
• The Turkish lira shows that credibility matters: high nominal rates did not protect holders while real rates were negative.

Next step

In the next lesson you will learn how to choose a forex broker: regulation, ESMA leverage limits and the real cost of spreads versus commissions.