Turkey: Fixing the economy with only bad options on the table

• President Erdoğan’s new economic team has started monetary policy normalisation. However, reversing the course without causing more pain is all but easy, as imbalances in the economy have been building up for a while.

• We expect the CBRT to gradually hike the policy rate to 25%, but at a pace insufficient to bring the real rate into the positive territory, particularly as recent lira depreciation is expected to fuel inflation going forward. Credit demand is expected to remain elevated, maintaining pressure on current account and lira.

President Erdoğan’s personal preference for low interest rates has caused severe damage to the Turkish economy. Inflation has skyrocketed, external imbalances have grown, and the central bank’s credibility and FX buffers have been eroded. As a result, an average Turk is poorer due to the loss of purchasing power; refinancing risks are on the rise particularly for those reliant on foreign borrowing; and the risk of an acute currency crisis remains as long as foreign reserves are very low.

How did Turkey end up in such a vicious circle? Obviously, low interest rates fuel inflation because a negative real rate encourages consumption and discourages savings. In Turkey, a low real rate has also led to net capital outflows and a rising demand for credit, which in turn, has boosted imports. Imports growth (where high energy prices are partially to blame) has topped exports growth, leading to a record-wide current account deficit. This implies that the country as a whole, all sectors included, is borrowing abroad. However, as capital outflows have same time been negative, the rising FX demand has led to a constant drain on foreign reserves – a factor that has further eroded the CBRT’s credibility.

After the run-off presidential election on May 28, President Erdoğan decided to appoint Mehmet Şimşek as the finance minister, and a few days later, Hafize Gaye Erkan as the new central bank governor. Both have background in banking and enjoy a good reputation. Yet, breaking free from Turkey’s vicious circle is all but easy. In our Research Turkey – Time to fasten seatbelts as Erdogan secures another term, 29 May, we highlighted the risk of lira depreciation in the absence of a policy turnaround. Thereafter, USD has gained more than 25% against lira despite the policy reversal. Why is that?

We think the recent fall in lira only underlines how the adjustment will be painful, particularly if you cannot go all in. We would have initially expected lira to appreciate once monetary policy is reversed but that would have necessitated that the CBRT would have hiked rates by so much the real rate would have been brought into the positive territory. In June, Turkish consumers still expected annual inflation at 39% end-of-year, so a 650bp hike by the CBRT, which brought the policy rate from 8.5% to 15%, was hardly sufficient. Hence, pressure on lira remains. Same time, lira depreciation in itself is also a reflection of policy normalisation: after the election, interventions in the FX market by state banks have been much more infrequent. Lira has been artificially strong, and now, in the absence of interventions, it is seeking a new equilibrium (although, in July, interventions seem to have resumed).

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