Turkey is in for a wild ride. High inflation and negative interest rates are eating away people’s income and savings.
The cause is a Hail Mary move by President Erdogan to save his political legacy. He is currently engineering a devaluation of the Turkish lira to establish a positive balance of trade. If he manages to achieve that Turkey can avoid to beg the International Monetary Fund (IMF) for a loan. High inflation is the price that he is willing to pay for that.
Today Erdogan reinforced his move:
Turkish Central Bank on Dec. 16 has lowered 1-week repo rate by 100 basis points to 14%, in accordance with the market expectations.
The Turkish central bank blamed consumer price increases on “developments in exchange rates and supply side factors such as the rise in global food and agricultural commodity prices, supply constraints, and demand developments.”
It said it would reassess “all aspects of the policy framework” over the first three month of 2022.
The Turkish central bank interest rate is now at 14% while the latest official inflation rate is at 21%. The real inflation rate is higher.
It is disingenuous for the central bank to blame consumer price increases on “developments in exchange rates”. The exchange rate of a freely traded currency is determined by the real interest rate, the difference between nominal interest rates and inflation:
In order to understand the so-called lira crisis, you have to understand the basic mechanics of currency and bond markets. The most important fact about currency and bond markets is that interest rates and exchange rates are jointly determined. The Turkish central bank can control either the exchange rate or the interest rate — it cannot control both in a world of free capital flows.
The lira has been falling gradually since 2014, before plunging precipitously this year.
When it comes to bread, a hallowed staple that Turks traditionally eat with every meal, the government has intervened significantly, pressuring bakeries to sell the traditional white loaf at a price lower than it costs to make, hoping to short-circuit the inflation that Mr. Erdogan fears could sow discontent and dim his election chances 18 months from now.
Grocery stores have been forced to stick to a fixed price for selling bread that is set by the Chamber of Bakeries, a trade association, but most bakers said the order came from the central government.
Yet, in a sign of the depth of the economic crisis, bread sales are down and bakeries, forced to keep prices to the level set by the Chamber of Bakeries, warn that they are facing bankruptcy.
“I cannot turn around the business,” said Ahmet Ucar, 39, whose bakery stood up the hill from the government kiosk. “The price of flour keeps increasing.”
Mr. Ucar said he had gone 100,000 lira into debt during the pandemic and now, with the currency crash, was struggling with the uncertainty caused by price fluctuations. “You cannot understand what the government is going to do next,” he said.
Turkey’s President Recep Tayyip Erdogan wants lower interest rates. He claims that high interest rates cause inflation and cites religious reasons against them. That is nonsense. What Erdogan really wants is pure mercantilism, to lower the value of the Turkish lira to increase exports:
Erdogan has sought and achieved a permanent devaluation of the lira, effectively lowering unit labor costs in Turkey thereby making Turkish workers more competitive relative to Germans. It’s what economists call a ‘beggar thy neighbor’ policy. [..] [Y]ou cannot understand what Erdogan is up to unless you appreciate the governing logic. Financial investors may be dumping lira assets but, with a weaker lira, Turkish products do become more competitive at home and in European markets, and Turkey does become a more attractive destination for FDI by global production firms looking to harvest lower unit labor costs.
The logic is hardly new. Americans have long claimed that China was intervening in currency markets to make Chinese products more competitive. The same allegation was made against the Japanese when Japan was threatening to become ‘number one’.
[T]here is nothing new about a medium-sized country pursuing a weaker currency to become more competitive. As a matter of doctrine, economists are loath to say that such a policy could ever be effective. But the proof of the pudding is in the eating. Countries pursue competitive devaluations because they work. Indeed, Turkish exports have responded enthusiastically.
Exports from Turkey surged 20.1 percent from a year earlier to record high of USD 20.79 billion in October 2021, amid a further global demand recovery and the falling lira. Sales grew for manufactured products (20.3 percent), agricultural goods (12.5 percent), and mining and quarrying (19.9 percent). The main export partner was Germany, followed by the US, the UK, Iraq and Italy.
Despite an increase in export and tourism, which also brings U.S. dollars, Turkey’s balance of trade in October was still at a negative -1437.90 million US$. But that was better than the -2591.34 million US$ deficit in September. Turkey has only a few billion U.S dollar left in its central bank reserves and can no longer afford a trade deficit. Erdogan is therefore trying to get to a positive trade balance where Turkey exports more than it imports and also attracts additional tourist revenue: Decrease the value of the lira -> increase exports and tourism -> balance the trade.
Turkish Deputy Prime Minister Ali Babacan pushed the button for paying off the last installment of its debt to International Monetary Fund (IMF) on Tuesday, and Turkey additionally committed IMF to extend USD 5 billion loan.
The last installment of Turkey’s debt to IMF was transferred by Babacan and the Undersecretary of Treasury Halil Canakci at Turkish Central Bank in Ankara. Babacan emphasized that Turkey should be proud of paying off the debt to IMF, with whom Turkey made 19 Stand-By agreements.
Turkey paid off its 52-year-debt with IMF –with whom Turkey affiliated in 1947– thanks to political stability and fiscal discipline.
Asking for new IMF support would bring shame over Erdogan. It would also reopen the door to U.S. meddling in Turkey’s policies. It is no wonder then that he is trying all he can to avoid that.
But there is of course a huge risk in what he is doing:
The main risk is that inflation may get out of hand. Some of the recent spike is simply ‘pass-through’ of the higher price of imported commodities as a result of the weaker lira. That’s by definition transitory. The real risk is an expectations spiral. If economic actors expect higher and higher inflation, things may well get out of hand.
It seems to me that the expectation spiral is already happening. This chart below is the inverse of the currency chart above. It shows a hockey stick like increase of the number of Turkish lira needed to purchase 1 U.S. dollar. Since mid November the value of the lira has slumped with ever increasing speed.
In order to contain [the expectations spiral] threat, the Turkish central bank will eventually have to raise interest rates, which would also stabilize the lira. Paradoxically, we will know Erdogan’s wager has succeeded precisely when he capitulates. By allowing the policy rate to rise, thereby stabilizing the lira and containing inflation, he would have secured a permanent devaluation and restored macroeconomic stability. The key is knowing when to fold.
Erdogan has shown himself capable of such tactical flexibility. As the FT notes, he’s ‘a wily pragmatist’ who let the central bank ‘raise interest rates during previous episodes of currency volatility’. This time, however, he ‘appears determined to follow through on his ideological commitment to low interest rates.’
By directing the central bank today to again decrease its interest rate Erdogan has achieved the opposite of stability. At a negative real interest rate of more than -7% the lira has now nowhere to go but down.
To stop the slump and to decrease inflation would now need a huge increase in interest rates. It would then put a brake on new economic activities as domestic loans in Turkey would suddenly become prohibitively expensive. Turkey’s economy would go into recession.
This ride betweenof Erdogan’s economic policies. Erdogan became prime minister in 2003. In 2014, after a change in the constitution he became president.
With no more funds available to defend the value of the lira Erdogan changed strategy and began the current Hail Mary move of intentionally dragging the lira down to thereby lessen the trade deficit. But the resulting high inflation is now a political burden which will make it difficult for him to win another election. To increase the interest rate early next year to stop the lira slump will likely be too late to repair the serious damage inflation is now causing.
But there is really little else that Erdogan can do if he wants to avoid a demeaning begging tour to the IMF.
The people of Turkey are in for a wild ride and an ever increasing inflation that will make all of them even more poor than most of them already are. Political instability in Turkey will increase as despair sets in. It is unlikely though that it will be sufficient to lead to Erdogan’s ouster before the elections in 2023.
A new government will by then have a politically really difficult task to right the half sunk ship without causing more peoples’ ire.