Now that the elections are over, the day of reckoning has arrived in Turkey. President Erdogan won a historic third term thanks in part to unprecedented financial luring. During the campaign, he spent billions of dollars to compensate citizens for high inflation, and tens of billions more to prevent the lira from a politically sensitive nosedive before the polls. And now he is being presented with the bill for his spending drive.
The status quo of artificially keeping the exchange rate of the lira stable has become unsustainable. Analysts predict a balance of payments crisis if Erdogan does not change course. Because Turkey has a large balance of payments deficit (the country imports more than it exports), so there is more demand for dollars than supply. But the central bank has spent its last foreign reserves this year to stabilize the lira ahead of the election and ensure Erdogan’s victory. Because foreign reserves are now negative, and interest rates (8.5 percent) are lower than inflation (43 percent), the pressure on the lira is enormous.
That is why the Turkish currency fell so quickly after the elections. The lira hit a new low against the dollar this week. The currency traded for nearly 21 against the dollar on Friday, bringing losses close to 10 percent this year. “The current lira selloff stems from the series of interest rate cuts that the central bank began in September 2021,” tweeted Robin Brooks, chief economist at the Institute of International Finance, the banking industry think tank. “Those interest rate cuts must be reversed to stabilize the lira.”
But Erdogan strongly opposes high interest rates, which he mistakenly sees as the cause of high inflation. He appointed one central bank governor after another until he found one willing to cut interest rates at all costs. The consequences were great. The lira ended up in free fall and inflation rose to 85 percent. It was a stark contrast to the policies of the first half of Erdogan’s rule, when Turkey was the emerging market of choice for foreign investors. But Westerners have left largely because of Erdogan’s erratic economic policies and his takeover of state institutions, once run by capable technocrats.
Implied threats
Meanwhile, the Turks are getting poorer. Because their country is dependent on imports and has a structural deficit on the balance of payments. So any fall in the lira translates into higher inflation. To prevent a further fall of the currency, the authorities have increasingly interfered in the currency markets, to the point that the lira effectively no longer has a floating exchange rate. The government introduced a deposit guarantee scheme that compensates savers for the depreciation of the lira. Exporting companies were also required to sell 40 percent of their foreign exchange earnings to the central bank. This gave the bank more ammunition to prop up the lira.
In addition, the government introduced implicit capital controls – although they should definitely not be called that. “Every time I talk to Turkish government officials about capital controls, they tell you, ‘Are you crazy? We can’t possibly have capital controls because we depend on foreign capital,” said Nick Stadtmiller, emerging markets strategist at Medley Capital, who lived in Turkey for many years. “Capital controls ensure that money stays in Turkey, but also that no money comes in. And that is not possible with a structural deficit on the balance of payments. You have to have a capital inflow to make up for that shortfall.”
Yet officials at the central bank and the Treasury Department admit, after some insistence, that soft capital controls are in place, Stadtmiller says. But they only apply to Turks, not to foreigners. This is confirmed by business people who say that they are called by the government when they transfer large sums of money abroad. “Hey, we heard you transferred money,” they say. ‘Why? What are you doing?’ This is often accompanied by implicit threats. “It would be a shame if a tax inspector suddenly knocked on your door next week.” Or: ‘Gosh, your factory needs an environmental certificate’.
In the run-up to the elections, entrepreneurs complained that they could not get cheap loans despite the low interest rates. The authorities forced banks to give priority to exporters and smaller companies that account for almost three-quarters of the labor market. “This created a two-rate economy,” says Stadtmiller. “For example, the government wanted to prevent the low interest rates from being used for hoarding in anticipation of future price increases. At the same time, they were still able to give some companies cheap credit, which is why they lowered interest rates so much. But they did prevent inflation from spiraling out of control.”
Survival mode
All this financial juggling was designed to boost economic growth and create jobs in the run-up to the election. And the government has certainly succeeded, says Emre Akcakmak, a senior consultant at Swedish asset manager East Capital. “In the last two years, as many jobs have been created as during the early years of Erdogan’s rule. He also raised the minimum wage [met 45 procent] and civil servant salaries. Citizens may not have been fully compensated for inflation, but their nominal incomes did increase significantly. That is more tangible to them than something as abstract as the central bank’s greatly diminished foreign reserves.”
However, these foreign reserves are closely monitored in the financial markets. Because net reserves fell last week for the first time since 2002. “The real risk for the banking sector is the fact that half of the deposits in banks are held by the central bank,” says Stadtmiller. “But the bank does not have enough reserves to cover those obligations. Multilateral financial institutions are very concerned about this. They fear for the stability of the sector. Because it can collapse in a week. If there is a bank run, it will happen quickly.”
Some analysts warn that banks could collapse because of the shortage of foreign exchange in the system. Akcakmak also sees that danger. “There are not many banking systems that can survive under the great pressure that Turkish banks have experienced in recent years,” he says. “There has been so much micromanagement with so many different rules and regulations. Those need to be addressed in a comprehensive manner, as there are many moving parts. And it is difficult to address a single point of distress for Turkish banks. Turkish companies only plan for the next three months and not much beyond. They are also in survival mode.”
Economic team
Meanwhile, the lira continues to fall. Now 1 dollar is worth about 21 lira. The currency will probably have to drop to 25 per dollar to satisfy exporters. They say their competitive position has been weakened by central bank interventions, which have caused the lira to be overvalued. “That depreciation had been coming for a while,” says Akcakmak. “Now that it is happening, it is a signal that the market believes that measures will be taken to address the problems in the economy. Because if you raise interest rates or address the balance of payments deficit, the lira will fall. Every step you take now will first cause pain.”
As the lira falls, the cost of the deposit guarantee scheme rises, into which citizens and businesses have already invested some $125 billion. Because the government compensates them for every drop in the lira. And deposits have grown faster recently as market interest rates on deposits have risen, Akcakmak says. “Now that the lira has started its long-awaited depreciation, the cost of the guarantee system may increase. So we need a clear exit strategy. Because the size of the scheme is already huge. $125 billion in deposits in a $900 billion economy is not something you can easily sweep under the rug.”
Erdogan has suggested after the elections that he wants to change course and return to more orthodox economic policies. “We are determined to take steps to compensate for the loss of wealth in various parts of our society,” he told entrepreneurs in the capital Ankara on Wednesday. He said his government has a good track record of fighting inflation – as it did in the first half of his rule. “We were the ones who relieved our people by reducing the structurally high inflation, which the economy had been struggling with for years, to single digits. And we will do that again.”
To achieve this, Erdogan wants to appoint an internationally respected economic team. He will present his new cabinet on Saturday. The president is in talks with Mehmet Simsek, an economist trusted by foreign investors. He was previously deputy prime minister and finance minister, but left when Erdogan appointed his own son-in-law to that post in 2018. His return will be a signal that Erdogan is ready to change course. But the question is how much room Simsek will get to take painful measures. Local elections will be held next year.
