With an unstable currency, volatility is a fact of life in Turkey. Like a business with volatile cash flows, Turkey is inherently risky. To survive the ups and downs in its economy, Turkey needs a strong balance sheet. And a strong balance sheet features a capital structure that includes a relatively small amount of debt and little leverage. As anyone familiar with corporate finance knows, to be safe, the risk in a company’s capital structure—its leverage—should vary inversely with the riskiness of the company. If you have a risky business, survival depends on a relatively small debt load and, consequently, low leverage.
Given its unstable currency, Turkey has grossly mismanaged its national balance sheet. It has way too much debt and leverage to safely weather the periodic storms that hit the economy.
To correct this dangerous state of affairs, Turkey faces two alternatives. It could abandon its national currency and replace it with a stable currency, either the euro or the US dollar. Such a currency reform would eliminate currency crises and make the economy much less volatile and risky. Accordingly, Turkey’s national balance sheet could afford to carry more debt and be more leveraged than if the lira was retained. Such a capital structure would allow Turkey to grow at a safer and faster rate.
Absent a currency reform, Turkey should reduce its debt load and leverage. In short, it should adopt a capital structure that would be appropriate for a risky business. To accomplish this, the government should place severe restrictions on both its own and the banking system’s borrowing in foreign currency. Such a less‐risky capital structure would provide safety and ensure survivability. However, this would result in a slower long‐run growth rate than that associated with the replacement of the lira with a sound currency.
Unfortunately, the program imposed on Turkey by the International Monetary Fund (IMF) fails to provide a solution to Turkey’s currency and national balance sheet problems. If Turkey continues to follow the IMF’s advice, it will remain in an economic trap.