IIt should be bring calm. Instead, Turkey’s election, which surprised investors on May 28 by reappointing Recep Tayyip Erdogan as president, has exacerbated the country’s economic woes. In the past two weeks, the lira has depreciated 5% against the dollar, falling to a 21-to-1 exchange rate. Some economists believe the figure could hit 30 by the end of the year despite government attempts to prop it up. The central bank’s net foreign exchange reserves are now in the red, having been depleted as savers and investors flee the currency.
Such difficulties are symptoms of an eccentric monetary policy. In 2021, Turkey cut interest rates amid inflationary pressures that prompted central banks everywhere to raise interest rates. Believing that low interest rates lower inflation – the opposite of economic orthodoxy – Mr Erdogan has repeatedly called on the Turkish central bank to lower its key interest rate. In fact, the overnight rate is currently a cool 8.5%. According to official figures, annual inflation reached 86% in 2022 (see Chart 1).
Since then, inflation has fallen – either to 44% according to official estimates or to a higher figure according to independent estimates. Mr Erdogan’s lackeys boast that he was right all along. In fact, inflation has fallen due to lower energy prices, central bank interventions in the foreign exchange markets and “base effects”, where past price increases raise the basis for calculating inflation. Irrespective of this, Mr. Erdogan is likely to continue his policy at least for a while. In his victory speech he emphasized that in addition to a looser monetary policy, “inflation will also fall”.
However, Mr Erdogan is right on one point. Turkey’s inflation puzzles economists, though not in the way he suggests. Persistently low interest rates and high inflation suggest that Turkey’s real interest rate has been deeply negative for some time. This is likely to quickly become unsustainable as it allows speculators to make sizeable profits by borrowing in lira and investing in stable assets such as real estate or other currencies, further depreciating the lira and driving up inflation. So how could real interest rates remain negative for so long? And what does that mean for the future course of inflation?
Looking for answers
First of all, one must first understand Mr. Erdogan’s approach. This was best expressed in 2018 when Cemil Ertem, a consultant, provided an overview, referring to an equation ingrained in many economic models and named after Iriving Fisher, a pioneering economist. The “Fisher equation” states that the nominal interest rate is the sum of the real interest rate and the expected inflation rate. Most economists believe that the real interest rate is determined by factors such as the long-term growth rate over which policymakers have little control. A lower nominal interest rate should, at least according to Mr. Ertem’s interpretation, lower inflation. Mr Ertem argued that this would happen if companies passed lower borrowing costs on to consumers as lower prices.
But when the theory was put to the test in late 2021, Mr Erdogan was proven wrong. Finally, inflation continued to rise. The problem was that the other channels through which interest rates affect inflation dominated the cost channel through which Mr. Ertem expected inflation to be reduced, says Koc University’s Selva Demiralp.
This means that the mystery of the persistently deeply negative real interest rate in Turkey still remains. But it’s starting to unravel when you factor in other types of real interest rates that haven’t been as negative. Emre Peker of Eurasia Group, a consulting firm, argues: “The [policy] The interest rate has become irrelevant.”
In some cases, interest rates are distorted by government policies. In the commercial sector, for example, banks are instructed not to lend above a certain interest rate. The result is that they simply avoid most loans. Only preferred sectors such as construction receive loans. Turkey has also required banks to hold bonds against foreign currency deposits, effectively subsidizing government borrowing.
However, in those sectors where interest rates are less distorted, nominal interest rates have moved in the opposite direction to policy rates (see Chart 2). As investors do not believe that the central bank will take any action to curb inflation in the future, inflation expectations have risen. This has led to higher consumer lending rates, particularly for longer-term loans, as investors demand a higher rate of return the lower they think the purchasing power of the lira will be in the future. Measured against consumer lending rates, real interest rates should therefore not be all that negative.
Likewise, the yields on other assets are much higher than the central bank’s interest rate suggests. This causes companies, households and investors to flee the currency. The government wants to support the lira but can only take limited action. Her correspondent was greatly blessed when, in a short time, he paid for a taxi in Istanbul in dollars at the market exchange rate, rather than the less generous black market rate. Suppliers are taking matters into their own hands and pricing items in dollars, points out Bekir, a shopkeeper at Istanbul’s Grand Bazaar. Non-FX assets are also attracting investment as parties struggle to protect their savings. Ms. Demiralp points out that there are, for example, “long queues in front of car dealerships”. House prices have risen three times faster than official inflation. Some are speculating about the possibility of an attack on the lira by foreign investors.
The government has tried to stem the currency flight. Exporting companies must sell 40% of their foreign exchange earnings to the central bank. At the end of 2021, the government introduced a system that protects some lira deposits from falling in value. In an extremely costly and not entirely sustainable situation, almost a quarter of all deposits are now covered.
What then of the Fisher equation? Short-term policy rates have been quite negative but are far less relevant to borrowing as market rates have either risen on higher inflation expectations or credit has been rationed. Elsewhere, the result has been a collapse in the lira, prompting the deployment of soft capital controls. If Mr. Erdogan were to keep market interest rates low across the board, the result could well be hyperinflation.
Some economists believe Mr Erdogan, armed with victory and facing a looming currency crisis, may soften his approach. Turkey will see some economic recovery in the summer when energy consumption will fall and tourism revenues will increase. Erdogan has been able to keep the lira afloat thanks to one-off foreign exchange deals with friends like Russia and Saudi Arabia. But in the fall, he may have to give up his promise to continue low interest rates, perhaps through indirect means such as easing interest rate caps on commercial loans. Warm weather and friendly favors don’t last forever. ■
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