Question

“The currency crisis in Turkey is being exacerbated by a skyrocketing annual inflation rate, which by some estimates, exceeds 100 percent. Countries with high inflation rates relative to others tend to see their currencies depreciate.

Over three weeks time, the Turkish lira has plummeted, with selling intensifying into Monday's record low of 7.24 lira per dollar after President Donald Trump on Friday said he would increase tariffs on steel and aluminum originating from Turkey. The escalating tariffs were a direct attack on Turkey's refusal to free jailed American pastor Andrew Brunson. (CNBC, August 14, 2018)”

“Since Turkey suffered an economic crisis of confidence in August – with its currency falling by some 25% that month – emerging markets around the world, from South Africa to Indonesia, have also experienced plummeting currencies and an outflow of foreign investment.

Argentina, which had stabilized after a crisis earlier in the year, has fallen back into emergency mode, increasing interest rates to 60%. Its currency, the peso, has fallen by 45% in 2018 and 24% in August”. (World Economic Forum, September 04, 2018)

One of the main reasons of this capital outflow from countries like Turkey is the fact that the Fed has been increasing the US Interest rate, up to almost 3%. Explain why a higher American interest rate causes an outflow of capital in other countries?

Answer 1

Globally, funds flow to the countries where interest rates are high.

Investors borrow from countries where interest rates are low, and invest in countries where interest rates are high.

In most cases, they only look at the nominal interest rates - while an in-depth analysis should also include real interest rates.

In economic terms, Net Capital Outflow depends on the interest rate differential.

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In the given scenario:

Due to high inflation in Turkey, the currency is depreciating. This is because real returns are low, and goods and services are also costlier. This makes exports costly as well.

Due to falling exports, sometimes these countries attempt to impose tariffs. This is however, counterproductive.

Though the nominal interest rates may appear high, investors are very skeptical due to the worsening conditions.

As soon as they see other developed countries raising interest rates, they start shifting funds from countries like Turkey, Argentina, Venezuela etc. to USA and Europe.

The higher interest rates in USA signify higher confidence and higher returns. Investors are also worried about safety of their funds.

These are the main reasons why outflow of capital occurs from most developing and underdeveloped countries, as soon as the Fed raises interest rates.