While Europe is grappling with a resurgence of the corona crisis and its adequate response, the situation at its borders is deteriorating too – Belarus, Ukraine, Libya to name but a few of the countries where important crises are ongoing. A case for particular concern though is Turkey, or so it should be, because the collapse of the lira doesn’t bode well.
The developments in Turkey are quickly told: the country’s currency, the lira, has plunged to a record, inflation is surging and has now overtaken the official rate of interest by as much as five percentage points. The latter was cut in several steps to its current level of 15 percent while inflation was going up and the lira down.
The president of Turkey, Recep Tayyip Erdogan, is known to have no time for monetary orthodoxy and insists that high rates are an evil and only low interest can put the economy right. He has enforced his unorthodox policy at the central bank and removed all vestiges of the central bank independence doctrine. To nobody’s surprise, markets have now lost confidence in the central bank and its ability to manage monetary policy, which contributed further to the fall of the currency. Today, the dollar buys 13.4 lira, while a year ago, the dollar was worth only 7.85 lira. This means that companies in Turkey have to pay almost the double for the raw materials if they are purchasing abroad – the consequences would appear dire.
Central Bank Stripped of its Tools
“The current strategy doesn’t look sustainable,” said Hakan Kara, a former chief economist at the TCMB, the Turkish central bank.
Indeed, it doesn’t. But the real issue is where it will all end. There are several factors that need careful consideration, not just by Turkey, but by its partners in Europe. The first aspect concerns the effect this development has on the Turkish economy, the private sector, the central bank and on consumers. The story of the central bank would appear the easiest to tell: no longer in a situation where it can set monetary policy according to what its experts deem necessary, it has lost control and merely implements what politicians say is right. And, from a situation where currency reserves already had reached a low point, the TCMB will have no real option to shore up the currency even if it wished doing so.
For the private sector meanwhile, a fall in the currency can mean two things. On the plus side, its products become cheaper for buyers in other currency regions, such as Europe. This is partially offset by the rise in raw material prices and unfinished products needed for its end-produce. For the huge tourism industry, a lower lira is good news, because it helps attract more guests from abroad, as prices appear to be lower for buyers in other currencies. If, however, for instance because of the pandemic, demand for holidays remain subdued, the comparative advantage may not amount to much.
Party Politics and Looming Elections
For the average citizen, high inflation and a drop in the currency is hardly good news. Inflation usually means that prices for goods rise faster than wages. At the same time, the prices of foreign goods will also surge because of the fall of the lira. Erdogan obviously expects that lower interest rates will keep the economy growing fast enough to help the country emerge from the corona crisis. But the risks with this strategy are substantial. Because, and that’s where politics enter the frame, elections are due in 2023. For all it is worth, the outlook for the ruling AKP has deteriorated in recent years. Taking Istanbul from the AKP in 2019 has given the opposition a boost. While the AKP still is the biggest party according to opinion polls, its has just over 30 percent support, while its nearest rival, the CHP, is closing in on that mark. Ekrem Imamoglu, who won the mayoral elections in Istanbul, is a member of the CHP. If he plays his cards well, he might be able to put a winning coalition together.
So, what are the options for the increasingly embattled president? A return to monetary orthodoxy is one. Kara believes that the most likely outcome of the current crisis is an increase in interest rates. But, as economists have pointed out in the past, such a return to monetary orthodoxy and central bank independence may not be such a quick and easy fix. Markets want to be convinced that the government has taken the point and that it will refrain from further meddling in the central bank’s affairs. How likely is this? It is worth looking back one year. In November 2020, Erdogan had appointed Naci Agbal as his new central bank governor after the lira had reached a record low. And, true to his credentials, Agbal set out to raise rates, adding two percentage points to the key rate in March 2021. The move earned the country a respite – and Agbal the sack. His replacement, Sahap Kavcioglu, was known to favor the unorthodox views of his political master and set about reducing the benchmark rate again. Starting at its September meeting, the TCMB cut the rate in three steps to the current 15 percent.
Return to Higher Rates Is Not on the Cards, Erdogan Says
On November 30, Erdogan made clear in a speech that he had no intentions of returning to higher rates again. Instead, he envisages even further cuts, saying that cheap cash will boost manufacturing, create jobs and slow inflation. Bloomberg cited him as saying: “Our country has now come to the point of breaking this vicious cycle, and there is no turning back from here.“
What he will do if domestic prices continue to go through the roof, is anybody’s guess. He might resort to financial repression and price controls, said economists. And then there’s the political field, an area where Erdogan has shown himself to be a master of making the most of his trump cards. The European Union will do well to keep a very close eye on the developments on the Bosporus, because in signing the refugee deal with Ankara, Erdogan has received a tool that he might be tempted to use if he feels cornered by the markets.
Turkey Has a Refugee Crisis Too
The reported figure of 5 million Syrian refugees stranded in Turkey has put a strain on the domestic situation in Turkey. With such a huge number of displaced people, few of which have options to return to their homes any time soon, Turkey might crave assistance with the enormous task of integrating them. As has been shown vividly at the border between Poland and Belarus recently, Europe has grown wary about accepting new refugees.
But Erdogan has also reached out to other neighbors. Interestingly, after years of antagonism, Turkey has started talking to Saudi Arabia, the United Arab Emirates and also envisages talking to Egypt. This is a key development in a region where two camps have made live very hard for each other. Turkey and Qatar on the one side had clashed with the Saudi, UAE and Egypt camp on the other side, notably so in Libya, where they fought a proxy war. One of the key issues was the purported support of Turkey for the Muslim Brotherhood, the sworn enemy of governments for instance, but not only, in Egypt. So, taking this step toward the Saudi camp was significant indeed. And, according to reports, the UAE has already pledged a $10 billion fund for investments in Turkey…
It is too early to say how Turkey will emerge from the current crisis, but the developments show clearly that it won’t be an easy task and that political steps might be the president’s preferred option over changing his opinion on monetary policy.