Ankara’s Economic Policy Dilemma

Inflation, currency depreciation and need for capital flows

The Turkish economy faces complex mone­tary and budget challenges. Annual infla­tion has been in double digits since late 2019, and is currently 64.8 per cent. The official unemployment rate is 10.2 per cent, youth unemployment 17.8 per cent; the actual rates are likely a good deal higher.

The Turkish currency collapsed again after Erdoğan won the second round of the presidential election on 28 May 2023, falling 18 per cent against the US dollar and 20 per cent against the euro within just two weeks. Despite the central bank’s interventions – six times in succession starting on 23 June – which cumulatively increased the base rate almost five-fold, the lira con­tinued to slide. This increased the prices of many imported inputs and energy (oil and gas), exacerbating cost and demand infla­tion and imposing significant costs on private households.

Another imbalance demanding intervention by the economic leadership was ex­haus­tion of the country’s foreign exchange reserves. By 12 May 2023 the Turkish cen­tral bank’s gross reserves had fallen by US$9 bil­lion to US$105.13 billion, the lowest level since July 2022. Its net cur­rency reserves shrank by US$4.45 billion to a 21-year low of US$2.33 billion, as demand jumped ahead of the elections. In order to stem the loss, the central bank ceased providing cheap money to commercial banks.

On 7 July 2023 the cost of Turkey’s credit default swaps (CDS) hit 503 base points (by comparison, Greece’s in 2010 was about 600 base points). This made state borrowing and refinancing immensely expensive, be­cause the higher a country’s CDS price, the lower its creditworthiness and the more likely its default. The price of insuring loans through credit default swaps increases accordingly. Here, the orthodox monetary policy of the past seven months has borne fruit, with CDS rates falling back to 304 base points.

According to the central bank, Turkey’s current account deficit was US$7.9 billion in May 2023, and totalled US$59.96 billion for the preceding twelve months – the highest level since July 2012. Turkey’s trade deficit was US$10.5 billion in May, with only services recording a positive contribution of US$3.9 billion (of which US$3.1 bil­lion were attributable to travel and tour­ism). Foreign direct investment was sub­dued in comparison to 2021 and 2022. Turkey increasingly attracts foreign direct investment in the form of real estate pur­chases; of the US$13.4 billion in FDI attracted in 2022, property accounted for US$6.3 billion.

The economic situation continues to force the Turkish government to scour the globe for investment, loans and above all capital. It was no coincidence that the first port of call for Finance Minister Mehmet Şimşek and Vice-President Cevdet Yılmaz was the wealthy United Arab Emirates. Media reports suggest that the sale of stakes in Turkish Airlines, Türk Telekom and the state gas supplier BOTAŞ were discussed.

Mollifying the financial markets

President Erdoğan advocates low interest rates and has called himself an “enemy of interest rates”. Rejecting the conventional economic teaching of raising interest rates to fight inflation, he attempted to boost the economy with cheap money, from Septem­ber 2021 instructing the central bank to lower interest rates despite double-digit inflation rates.

Supporters of Erdoğan’s course believed that although falling rates would initially increase inflation and devalue the lira, this would also make Turkish goods more com­petitive internationally and boost exports. Imports, on the other hand, would decline as they became more expensive. Turkish manufacturers would reduce their reliance on expensive imported inputs and seek domestic suppliers instead. Import sub­stitution, the theory went, would boost domestic manufacturing.

At the same time a weaker lira would incentivise foreign investment and tourism. Foreign currency inflows from increasing tourism, foreign direct investment and exports would compensate the negative current account and strengthen the lira – and ultimately bring down inflation.

That theory has failed to work out in practice. Inflation has remained high, the current account deficit has grown and the lira has fallen massively. The 23 June meeting of the Turkish central bank’s monetary policy committee was therefore eagerly awaited. Its decision on interest rates was expected to reveal the earnestness of Erdoğan’s economic policy turn. How­ever, even before the meeting the president told the press that he was sticking to his theory of “low interest rates, low inflation”. The committee then decided to raise the base rate from 8.5 to 15 per cent. This was supposed to initiate a gradual tightening of the money supply to bring down inflation.

The step was welcomed as a moderate change of course, although falling short of expectations. Sceptics have rightly objected that the markets were probably not greatly influenced by the interest rate hike. The cen­tral bank continued to supply cheap fundi­ng to the commercial banks and mean­ingful change in interest rates for loans, deposits and bonds was not a realistic expec­tation.

It appears that the appointment of Şimşek and Erkan was conceived as a stop-gap, principally to create the impression that Turkey was returning to an orthodox economic course, in the sense of a policy based on conventional assumptions priori­tising market mechanisms. The intention behind this was to stimulate capital in­flows.

Another cause for concern was Erdoğan’s reiteration – speaking to the media on a flight back from Azerbaijan – that he was seeking loan deferments and new sources of funding. The monetary policy committee’s statement that the central bank would “continue to support strategic investment” did nothing to allay fears that it could be forced to pursue objectives above and beyond monetary stability. Apart from Erkan, all the committee’s other four mem­bers had approved past base rate reductions while inflation was rising. Their abrupt about turn on 23 June will have done noth­ing to restore confidence. Although Presi­dent Erdoğan’s replacement of three deputy governors in July represented political back­ing for central bank governor Erkan, sus­picions linger that he could still revoke the orthodox turn.

Socio-political dilemmas

It is worth considering the potential con­sequences if Turkey had reinstated the orthodox monetary policy more abruptly by increasing interest rates much more sharply. Firstly bond prices would have fallen significantly, devaluing the banks’ assets and placing them under massive pressure. Secondly the cost of borrowing would have increased immensely, raising consumer prices and reducing demand. Economic recession would have been a real possibility. Thirdly a sudden hike in interest rates would have caused a rapid exit from foreign exchange–protected accounts, in­creasing demand for foreign currency in an already dollarised economy and exacerbating the problem of foreign exchange liquid­ity. By mid May 2023 there was the equiva­lent of US$121.6 billion in foreign ex­change-protected accounts. As of 1 January 2024 it is no longer possible to open a new foreign exchange-protected account and existing ones will not be renewed when they expire. Fourthly, a drastic interest rate hike would have greatly strengthened the lira, to the detriment of Turkey’s exports and tourism sector. Instead interest rates were increased gradually.

Three groups have profited from Erdo­ğan’s policy of keeping interest rates low. Cheap borrowing secured lucrative con­tracts for the construction sector, a weak lira made exporters more competitive, and low interest rates for credit cards, mortgages and car financing eased consumption for private households. The loss of purchasing power for low-income families was com­pensated by increasing the minimum wage.

All this places Erdoğan’s new government on the horns of an economic policy dilemma. If it continues to pursue strong growth it faces spiralling inflation, currency crisis and in the worst case sovereign default. If it returns to high interest rates, strict budget discipline and rigorous sup­pression of inflation – at the price of weaker growth – Erdoğan must expect to lose not only voters but also backers. The latter cen­tre around businesses in the con­struction, tourism and defence sectors, all of which he has rewarded with cheap loans and state con­tracts. Minds are focussed by local elec­tions scheduled for March 2024, where Erdoğan and the AKP hope in particular to regain control of Istanbul and the capital Ankara.

Preconditions for rebuilding confidence

Weak institutions and the reform backlog also represent impediments to restoring the health of the Turkish economy. Com­prehensive structural reforms could restore con­fidence in Turkey and its economy. That would contribute to strengthening the lira and making the country attractive to for­eign investors again.

Turkey needs inclusive institutions, demo­cratic rules and an effective legal sys­tem. That means ensuring economic oppor­tunities for all, free and equal access to resources, and their effective utilisation for the benefit of all. Determined action to com­bat corruption, proper transparency in state procurement and democratic renewal are needed too. It would also be important to improve the quality and reliability of the economic data provided by the Turkish Statistical Institute, to create a modern, in­clusive and creativity-promoting education system, to improve the rights of women, and to promote their participation in soci­ety. As far as the latter two points are con­cerned, rejoining the Istanbul Convention would be a good first step and a positive message to the West.

The Turkish economy stagnated over the past decade, measured in terms of growth in per capita GDP, which fell from US$12,582 in 2013 to US$10,655 in 2022. In the 2000s Turkey was still achieving average annual growth of 6 per cent, with per capita GDP tripling between 2002 and 2013. That period also saw comprehensive reforms, democra­tisation, adaptation to the EU acquis, and the establishment of integrative institutions and regulatory instances. The dilemma for Turkey’s leaders is political too: that kind of reform agenda conflicts with the objectives of the governing bloc and the alliance of parties on whose support Erdoğan currently depends.

Consequences of a Turkish economic crisis for the EU

As we have seen above, the Turkish econo­my is a long way from the road to rapid recov­ery. Yet any protracted crisis would have consequences for the EU’s own economy and security.

Outlook and Recommendations

If Turkey ends up facing stagflation that would weaken its ability to deter and con­tain Russia. In that light, close cooperation between Brussels and Ankara is the order of the day. The EU’s relationship with Turkey had been complicated in recent years by devel­opments including the Turkey’s own internal politics. Nevertheless, Turkey is a NATO member, and more important than ever for the EU’s security. As a direct neigh­bour and a regional power in the Black Sea and Mediterranean regions, Turkey plays an important role in managing migration routes, in counter-terrorism, in securing maritime trade routes, and in containing Rus­sian ambitions.

Turkey’s rise to become a regional power challenging but also balancing with Russia – and also supporting Ukraine militarily – makes it a more vital partner than ever for Germany and the EU. It is therefore neces­sary to tie Turkey closer to the EU’s security architecture, in which NATO has an impor­tant role to play. There is also scope for co­operation on combatting irregular migra­tion and human trafficking, for example in the scope of the European Border and Coast Guard Agency Frontex and the Standing Nato Maritime Group 2. Cooperation is also conceivable in the framework of the EU defence initiative PESCO, which permits third-country participation; Ankara has already indicated its interest.

Under these circumstances Berlin and Brussels would be advised to pursue a criti­cal but pragmatic policy towards Turkey, taking account of the changing strategic situation and Ankara’s economic and secu­rity interests. One important step would be to modernise the EU’s customs union with Turkey. That could boost prosperity on both sides, if the agreement can be expanded to cover services and unprocessed agricultural goods, and if it were possible to improve terms for Turkish goods vehicles transiting to and through the EU member states. Tur­key is also interested in being consulted on new EU customs agreements with third states. Negotiations to reform the customs union would contribute to overcoming the uncertainty among European economic actors about Turkey’s future relationship with the EU.

In the sphere of economic cooperation the European Investment Bank (EIB) and the European Bank for Reconstruction and Development (EBRD) also offer possibilities. They could provide funding for reconstruction of the regions affected by the February 2023 earthquake, making it conditional on effective action against corruption, for exam­ple in the construction sector, and trans­parency in state procurement. Con­ditionality of that nature would also address criticisms of Turkey within the EU.

In the case of Germany there are numerous state and civil society platforms for bi­lateral cooperation. To highlight just three of these:

• The German-Turkish Chamber of Indus­try and Commerce has about one thou­sand members. It could play an impor­tant role in deepening cooperation in the vehicle and component, energy, machine-building and defence sectors.

• The Joint Economic and Trade Commis­sion (JETCO) was established in 2013 as a cross-sectoral platform aiming to im­prove bilateral cooperation above all in the fields of trade, industrial cooperation, tourism and infrastructure, and to develop concrete projects. It includes an annual meeting chaired by the two economy ministers.

• The German-Turkish Energy Partnership was created in 2012 under an agreement between the Turkish Ministry of Energy and Natural Resources and the German Federal Ministry for Economic Affairs.

These three platforms could contribute to advancing the political and economic dialogue between the two countries, ad­dress­ing bilateral differences and exploring further possibilities for cooperation.