One of the constant concepts in President Erdogan's economic logic is that increasing the interest rates to strengthen the Lira is not a good economic policy because it will discourage investment and slow down the economy. He further believes that a weak Lira (Turkey's national currency) will promote exports and the growth of exports will create jobs by increasing demand for Turkish goods and services. Successive governors of Turkey's Central bank have opposed this vision and have tried to strengthen Lira only to be replaced by a new governor. President Erdogan has replaced the Central Bank governors four times since April 2016. These rapid replacements sends the wrong signal to domestic and international investors alike.
They also point to a lack of central bank independence, which is considered an institutional necessity for price stability. The argument is that politicians are under pressure to increase government spending which often leads to government deficits and if appointed politicians control the central bank, they will force it to finance this deficit by printing money. The increase in money supply will then result in inflation and higher prices. An independent central Bank director will be able to resist these political pressures and focus on using its monetary power to achieve price stability.
The Lira has lost more than 53% of its value against the US dollar between January 1st and December 20th of 2021. On January 1st one dollar was exchanged for 7.7 Turkish lira, but the sharp depreciation of lira raised this exchange rate to 16.66 lira per US dollar on December 20th. In the past the Turkish central bank responded to this type of depreciation by raising interest rates to make savings in Turkish lira more attractive. This time, it has followed President Erdogan's logic and has lowered the interest rates. At the same time the Bank's hard currency reserves are relatively low and it has not been able to prevent the sharp fall of Lira since early October 2021.
The exchange rate crisis has had a severe impact on households buying power as the price of many essential items has increased at a faster pace than the wages and incomes. A visible sign of the difficult economic conditions are the long lines in front of government-owned bakeries that sell bread at a subsidized price. The cases of property theft, that are motivated by poverty, have also increased.
The current economic crisis is fast evolving into a political crisis. For the past two months there have been several mass protests against the rising inflation and poverty. The opposition political parties have also become very vocal in their criticism of these policies. The Nationalist Movement Party (MHP) leader, Devlet Bahceli, has stood by President Erdogan and accused the opposition parties of plotting to harm the economy by their sharp criticism of the government's low interest rate policy. At the same time, both Bahceli and President Erdogan have condemned the countries largest business association, Tusiad, for opposing the low interest rate policy.
Turkey is not the only emerging market economy in which the independence of the central Bank has been undermined in recent years. In Brazil and Indonesia, the central Banks have also been forced to support the government's budget deficit in response to the Covid-19 pandemic. In these two countries, however, the rising inflation rate and the associated depreciation of the national currency has not been as severe as Turkey in 2021.
While insisting on his low interest rate policy, President Erdogan is showing significant flexibility in foreign policy. Turkey has launched an active campaign to improve its tensions with oil-rich Persian Gulf Arab countries and Egypt. After the Arab Spring uprisings (2010-11) Turkey's relations with Egypt, Saudi Arabia, and the UAE deteriorated and tensions escalated after Turkey supported Qatar in ts dispute with these countries. The killing of Jamal Ghashogchi in Istanbul in 2018 added to these tensions. Now it seems that Turkey is trying to improve these relations. Most experts believe that the current economic crisis has served as a motivation for this initiative. Saudi Arabia and the UAE were among Turkey's major investors when the diplomatic relations were good.
The economic crisis itself is spreading from the exchange rate to the banking sector. Many Turkish Banks have large debts in hard currency (euro and US$). As a result of the currency devaluation the cost of borrowing and servicing this debt has risen significantly in the past two months and is likely to rise even further in the next few weeks. This will increase the risk of default by some if these banks. The debt insurance for lending to Turkish financial institutions is already rising and this will further add to the cost of borrowing for Turkish banks.
In his latest reaction to the crisis, President Erdogan announced on Monday, December 20th, that it is his Islamic obligation to keep the interest rates low. He reiterated his commitment to this policy despite the worsening crisis. This strategy will upset the business community and the ordinary people who are feeling the pain of rising inflation, but President Erdogan believes that it will reassure his conservative religious supporters.
December 21: President Erdogan announced a new banking policy on Monday evening (December 20th) that caused a reversal in exchange rate. He announced that the Turkish government will compensate the lira denominated personal time deposits (with lengths of 90 days and twelve months) in the banking system against the depreciation of Lira. This policy put an end to the depreciation of lira but led to wild swings in the exchange rate on Tuesday, December 21st. It reduced the price of US$ from 18 lira to 11.5 lira but it is not clear if this lower rate will hold. The policy will expose the Turkish government to a potentially large financial commitment, which might lead to higher budget deficit and more inflationary pressure. This policy follows another economic policy announcement a few days ago (December 16), which raised the minimum wage by 50%. This wage adjustment was popular in face of the severe decline in purchasing power of wage-earners but it will also increase the government's wage obligation and increase the budget deficit.
This guarantee on time deposits is an implicit interest rate increase for depositors. The investors that keep their savings in lira accounts will be compensated with a fixed interest rate plus a compensation for depreciation of lira against the dollar. Together these two payments are equivalent to a variable interest rate that will increase when Lira depreciates.
This policy can be effective in the short run as demonstrated in the immediate reaction of the lira exchange rate. If the government can effectively control the budget deficit and the money supply, it can succeed in the longer run, but it will not be as efficient as a standard interest rate adjustment policy. A major risk factor in the case of Turkey is that under its current political climate it will be very difficult for President Erdogan to maintain fiscal discipline. For this policy to be successful the Turkish government has to use all means available to prevent the Lira from depreciating significantly in the coming months. Otherwise the financing of exchange rate compensations on these guaranteed deposits can worsen the budget deficit and inflation rates.
December 22: Another risk factor that must be taken into account is that the Turkish government has borrowed a large amount of hard currency in recent years to finance major development projects. The sovereign external debt of Turkey has increased steadily from $85 billion in 2010 to $184 billion in 2021, of which about one third is owed to the domestic banks and financial institutions. Fortunately, the government regulations forced the banking system to reduce its external hard currency debt after the 2018 currency crisis.
While the external debt of Turkish banks has declined from over $150 billion in 2018 to $94 billion in 2021, the hard currency deposits of Turkish citizens has increased to $252 billion (as of November 2021). What these figures imply is that the Turkish Banking system is more resilient than three years ago to cope with the current currency crisis. Yet at the same time it is more vulnerable to any potential hard currency shortages in the government or the Turkish Central Bank, which has also increased its hard currency borrowings from the domestic banks. The central bank and state-owned banks used up a substantial amount of reserves to support the lira in recent years.
December 23: President Erdogan's new policy of exchange rate guarantee led to appreciation of lira for the third day. The exchange rate declined to 10.85 lira per dollar. (It was 18.5 lira on December 20th before the policy was announced.) This "exchange rate rescue policy" will be successful in the long run if the government is able to stabilize the exchange rate by applying all the resources and policy tools at its disposal. The fiscal and monetary policy must now give a higher priority to price and exchange rate stability than any other goal. This implies that President Erdogan's earlier focus on reducing the interest rate and exchange rate to assure the competitiveness of exports has to take a back seat.
Opposition leaders believe that the success of this plan is only temporary because it will be politically very difficult to maintain fiscal and monetary discipline. They worry that the plan will put a very large financial burden on the government when the exchange rate rises again in a few months. The compensation will be very large and it will either cause more inflation (if government prints money) or slow down the economy (if government cuts back other expenditures or increases taxes.)
