The Turkish economy has been struggling in recent years, experiencing a rapid depreciation of the lira, and a surge in inflation. Whilst this may appear to resemble the market difficulties of the 1990s, and partly reflects the inflationary pressures affecting all of Europe at the moment, the underlying mechanisms are distinct and mostly self-inflicted. The recent economic situation in Turkey serves as a stark reminder of the consequences of mishandling monetary policy. Recent appointments in the finance ministry and central bank suggest a possible return to more orthodox policies. However, the lack of acknowledging past policy failures raises doubts about the sustainability of any changes made.
Turkey has faced a combination of economic challenges including unstable growth rates, significant currency devaluation, and surge in inflation.
Over the past decade, Turkey has faced a combination of economic challenges including unstable growth rates, significant currency devaluation, and surge in inflation.[i] In recent years, these issues have worsened, partially due to external factors such as the COVID-19 pandemic and the war in Ukraine, leading to very imbalanced pattern of growth and a significant accumulation of potential risks within the economic system. Turkish President Recep Tayyip Erdoğan’s unconventional monetary policy[ii], characterized by low interest rates and heavy reliance on credit, has played a significant role in exacerbating these issues. With President Erdoğan securing another term, concerns over the direction of the monetary policy are stronger than ever and raising alarms for the future stability of Turkey’s economy.[iii]
The economic landscape hasn’t always been this way. In fact, during the first 10 years of President Erdoğan’s rule, both he and the AKP were widely regarded as capable, conservative, and careful in their approach to economic policy. Yet, from the mid-2010s, Turkey started grappling with significant challenges. Political risk increased, partly due to the 2013 Gezi Park protests, and a coup attempt in 2016. Partly in response to this, the government started to erode the capacity and independence of state institutions.
In an effort to counter the economic decline during that period, the government implemented substantial infrastructure investments and low interest rates to encourage domestic borrowing. During this period, it was widely suspected that the central bank was being forced to keep interest rates low.[iv] However, these measures resulted in significant trade deficits, increased reliance on external credit, rapid depreciation of the lira, and a loss of confidence in monetary policy driven by prolonged periods of negative interest rates and mounting inflationary pressures.
The Turkish Monetary Policy Experiment
The weaker lira does seem to have helped export growth in the last couple of years.
Central bank independency in Turkey has been on decline in recent years. President Erdoğan’s actions indicate that he does not hesitate to dismiss central bankers and finance ministers if they do not comply with his wishes. Since 2020, three officials have been dismissed from their positions without a clear explanation, sparking speculation that their refusal to lower interest rates may have been the primary reason for the termination[v]. President Erdoğan believes that higher interest rates are the cause of rising prices, not a cure for them. He argues that keeping interest rates low will encourage consumer spending, business investment, and job creation.[vi] He also claims that a weaker Turkish lira against the US dollar would make exports more affordable, leading to increased demand from foreign consumers.
There is some truth to his arguments. The weaker lira does seem to have helped export growth in the last couple of years. And cheap credit has certainly supported consumer spending. Yet, these policies engender significant consequences.
Many analysts believe that the actual inflation rate on the streets is even higher than the official figures suggest.
Turkey heavily relies on imports such as fuel, gas, medicine, fertilizer, and other raw materials. When the value of the lira declines, the cost of purchasing these goods increases. Additionally, President Erdoğan’s unconventional monetary policy has raised concerns among foreign investors[vii] who were previously willing to lend substantial amounts of money to Turkish businesses. Furthermore, implementation of lira saving scheme “KKM”[viii], a state-backed foreign exchange-protected deposit, is transferring the risk of exchange rate fluctuations to the public sector, giving a rise to substantial contingent liability, and posing a risk for domestic financial stability.
At the beginning of 2022, when central banks in Europe and the United States started to introduce tighter monetary policies by raising interest rates to tackle inflation, the Turkish Central Bank, in contrast, lowered its interest rate. This unconventional strategy has led to sharp depreciation of the lira and ever-more elevated inflation rates, with the year-on-year inflation rate reaching a 24-year high of over 85% in October 2022[ix]. Many analysts believe that the actual inflation rate on the streets is even higher than the official figures suggest[x].
Targeting and Countering Inflation
As long as real interest rates are deeply negative, the lira will depreciate, imported inflation will surge, and the economy will suffer.
To counter the impacts of surging inflation, the Turkish government has implemented several measures. These include raising the minimum wage and public worker wages by 55% and 45%, respectively.[xi]
Beside the introduction of the KKM scheme, the government has also enforced strict regulations on foreign-currency transactions conducted by companies. However, the effectiveness of these measures appears to be limited. As of April 2023, Turkey’s annual inflation rate was 43.7%[xii], showing a downward trend due to base effects, but still extremely high compared to peer countries.
Rising inflation rates in Turkey, along with an increase in import prices and production costs, create major difficulties for households and businesses alike. Low-income households struggle to afford basic necessities as prices skyrocket, while businesses find it challenging to plan and invest in new projects due to unpredictable returns and mounting costs. In Turkey, just like in any other country, inflation is influenced by factors related to both demand and costs. Therefore, raising interest rates alone would not address the issue. It is essential to also keep in mind cost factors such as higher energy prices. Yet, it remains clear that as long as real interest rates are deeply negative, the lira will depreciate, imported inflation will surge, and the economy will suffer.
What Does the Future Hold?
Accurately assessing demand and cost factors remains crucial for effectively managing inflation and utilising interest rate policy in Turkey.
Following his re-election in May, President Erdoğan has appointed market-friendly former minister Mehmet Şimşek as the finance minister[xiii] and former Wall Street executive Hafize Gaye Erkan as the central bank governor[xiv], indicating a potential shift towards normalizing Turkey’s monetary policy.
Until now, the central bank has taken steps to reduce its interventions in the currency markets and on June 23, the central bank implemented a notable 6.5 percentage point increase, raising the policy rate to 15%, and in July 2023, this rose again to 17.5%.[xv] Nevertheless, these actions were not as aggressive as markets anticipated.
Finance Minister Şimşek stated that Turkey’s economic policies will prioritize “price stability, financial stability and macroeconomic stability” through gradual actions[xvi]. While the lack of acknowledging past policy failures raises concerns about the sustainability of these changes, the appointments and the recent policy changes reflect Erdoğan’s recognition of the seriousness of the situation. Although the duration of these changes may be influenced by the downward trajectory of inflation, it is likely that interest rate hikes will be implemented for a period of time.
Accurately assessing demand and cost factors remains crucial for effectively managing inflation and utilising interest rate policy in Turkey. A change in the monetary stance to something more orthodox, targeting small positive real interest rates, would not solve all of Turkey’s economic problems but certainly improve macroeconomic stability and provide the basis for a more stable growth rate.
However, even without this, the economy has shown itself remarkably resilient. If foreign funding continues to arrive to plug the large current account deficit, it is likely that the year 2023 will end with a growth rate of around 2.6% and an inflation rate ranging between 40-45%. The implementation of Turkey’s “zero price” method for gas inflation measurement resulted in a notable reduction in inflation in May. However, recent depreciation in the exchange rate may limit the effectiveness of this approach.
[i]Kubilay, M.M. (2022) “The Turkish Economy under the Presidential System”, Middle East Institute, 13 October 2022, https://www.mei.edu/publications/turkish-economy-under-presidential-system.
[ii] Ant, O. and Yilmaz, U. (2022) “What Erdogan’s Unusual Economic Ideas Mean for Turkey”, The Washington Post, 27 September 2022, https://www.washingtonpost.com/business/what-erdogans-unusual-economic-ideas-mean-for-turkey/2022/09/23/9c5e8374-3b3d-11ed-b8af-0a04e5dc3db6_story.html.
[iii] Financial Times (2023) Turkey’s economic fate is still in the president’s hands, 6 June 2023, https://www.ft.com/content/c354a4c7-1382-4a0a-b1c3-97a019d9da5a.
[iv] Alderman, L and Rao, P.S. (2018) “Defying Erdogan, Turkey’s Central Bank Raises Interest Rates”, The New York Times, 13 September 2018, https://www.nytimes.com/2018/09/13/business/turkey-central-bank-interest-rates-erdogan.html.
[v] See Reuters (2021), Factbox: Revolving door: Turkey’s last four central bank chiefs, available at https://www.reuters.com/world/middle-east/revolving-door-turkeys-last-four-central-bank-chiefs-2021-10-08/ and CNBC (2021), Turkey’s Erdoğan names Nebati as new finance minister as lira skids, available at https://www.cnbc.com/2021/12/02/turkeys-Erdoğan-names-nebati-as-new-finance-minister-as-lira-skids.html.
[vi] Young, M. (2021) “Why is Turkey’s President Cutting Interest Rates, Spurring Inflation and Lowering the Value of the Lira?”, Carnegie Middle East Center, 2 December 2021, https://carnegie-mec.org/diwan/85896.
[vii] Turak, N. (2022) “Erdogan blames Turkey’s currency problems on ‘foreign financial tools’ as central bank reserves fall”, CNBC, 13 January 2022, https://www.cnbc.com/2022/01/13/erdogan-blames-turkeys-currency-woes-on-foreign-financial-tools-as-central-bank-reserves-fall.html.
[viii] Daily Sabah (2022) “Scheme to protect lira savings helps cut FX deposits: Turkey”, 23 March 2022, https://www.dailysabah.com/business/finance/scheme-to-protect-lira-savings-helps-cut-fx-deposits-turkey.
[ix] Sonmez, M. (2022) “Turkish inflation hits 85.5% as doubts linger over official data”, Al-Monitor, 3 November 2022, https://www.al-monitor.com/originals/2022/11/turkish-inflation-hits-855-doubts-linger-over-official-data.
[x] DW (2022), “Inflation in Turkey: Researcher won’t hide the figures Erdoğan doesn’t want to see”, available at https://www.france24.com/en/asia-pacific/20220622-inflation-in-turkey-researcher-won-t-hide-the-figures-Erdoğan-doesn-t-want-to-see, and Euronews (2022), Soaring inflation and a collapsing currency: Why is Turkey’s economy in such a mess?, available at https://www.euronews.com/2022/11/09/everything-is-overheating-why-is-turkeys-economy-in-such-a-mess.
[xi] Yackley, A.J. (2022) “Erdogan raises Turkey’s minimum wage by 55%”, Financial Times, 22 December 2022, https://www.ft.com/content/77b615a9-fa88-4194-8949-dc2bba82fb79.
[xii] Kucukgocmen, A. (2023) “Turkish inflation slows to 43.7%in April ahead of elections”, Reuters, 3 May 2023, https://www.nasdaq.com/articles/turkish-inflation-slows-to-43.7-in-april-ahead-of-elections.
[xiii] Hacaoglu, S. Kozok, F. and Ozsoy, T. (2023) “Erdogan Taps Markets Veteran Simsek as Turkey’s Finance Minister”, Bloomberg, 3 June 2023, https://www.bloomberg.com/news/articles/2023-06-03/erdogan-names-simsek-as-finance-minister-as-policies-get-rethink?leadSource=uverify%20wall.
[xiv] Samson, A. (2023) “Hafize Gaye Erkan, a new central bank governor takes on troubled Turkey”, Financial Times, 10 June 2023, https://www.ft.com/content/1ea9cf66-ca6b-453d-9e2a-e5ae15877a70.
[xv] Tavsan, S. (2023) “Turkey raises interest rate to 15% from 8.5% to fight inflation”, Nikkei Asia, 22 June 2023, https://asia.nikkei.com/Economy/Turkey-raises-interest-rate-to-15-from-8.5-to-fight-inflation.
See also: Turak, N. (2023) “Turkey’s Central Bank Raises Interest Rates Less Than Expected, to 17.5%”, CNBC.Com. https://www.cnbc.com/2023/07/20/turkeys-central-bank-raises-interest-rate-less-than-expected-to-17point5percent.htmlTurkey’s central bank raises interest rate less than expected, to 17.5% (cnbc.com)
[xvi] Simsek, M. (2023) Twitter.com, https://twitter.com/memetsimsek/status/1672188933227048961
