Adventurous economic policy experiment in Turkey

The end of June and the first week of July are the anniversaries of three significant developments in Turkey for the past two years. The first is the second anniversary of the “presidential government system” that was formed after the June 24, 2018 presidential elections and the cabinet of that system that was announced on July 9 of the same year.   

The second is the anniversary of the week when the March 31, 2019 local elections were repeated (with invented and enforced reasons) for Istanbul on June 23, 2019, which the ruling party lost the largest city of Turkey with a huge difference.  

The third is the anniversary of the dismissal of the Central Bank Governor Murat Çetinkaya in the first week of July immediately after this election defeat. 

The correlation among these three is the collapse and institutional failure of the “Turkish type presidential system” that was formed with a lot of boast, the political damage that occurred in the local elections and following these, the sliding to an adventurous economy policy. 

Immediately after the presidential election, a negotiation in the style ridiculed as “Give me the imam, I’ll give you the pastor” was attempted with the U.S. but this turned into a blackmail diplomacy. The threats and the embargo came from the U.S. and following them, an economic crisis triggered in August 2018 in the already fragile economy.      

This crisis led to what is called “sudden stop” in the economy, stopping the capital inflows movements, causing capital outflows and a credit crunch. These led the economy to a severe recession. 

In June 2018 when the presidential elections took place, last four quarter total gross domestic product (GDP) was 884 billion dollars. It is expected to be around 700 billion dollars at the end of 2020. There is a distinct drop. 

In the first days of the 2018 crisis, Ankara’s words, “They declared economic war on us” further frightened the residents. With more mismanagement, the crisis was spread to a wider zone and time. Major parts of the steps taken were bans, restrictions and other threatening steps that distanced the economy from the free market; domestic and international concerns grew even more. 

After the lost 2019 local elections, the adventurous economy policies were totally based on getting hold of central bank resources and extreme credit expansion, as well as pressuring private banks to lend and also putting pressure on private entrepreneurs over their prices and investment decisions. 

Local election shock 

After the ruling party lost two major cities in March 31, 2019 elections, which forced the repetition of Istanbul elections, then lost the Istanbul elections again on June 23, everybody’s eyes turned to the economy again. The question was whether a solution would be found for recession. 

After the August 2018 crisis, there were no signs yet of any recovery from the recession. In that period until June 2019, there were attempts to “cover” the consequences of the crisis rather fight the causes. In order to veil unemployment, for a long time, employment figures were not issued due to the reason of “reconstructing the website.” After the August 2018 crisis, when the exchange rate shock affected inflation, there were attempts to veil that also. There were phone calls from Ankara to producers pressuring them to drop prices. There were stands set up at city squares selling cheap fruit and vegetables. To prevent the climb of the forex rate, Central Bank’s reserves started to be eroded through “back door” methods. This was being hidden by swap transactions. 

After the elections, everybody was wondering whether a new policy would be adopted. After losing two megacities such as Ankara and Istanbul, my prediction was that the government would opt for “more adventurous economy policies” to regain the lost ground. It did happen so. 

Ankara did not fail us 

In the first week of July, the first step of what I define as “adventurous economic policies” was taken on July 6, 2019, with the dismissal of the Central Bank Governor Murat Çetinkaya.  

It was more than obvious that Ankara associated the loss in local elections with economic developments. They accelerated their efforts and whoever blocked them was to be removed; one of them was the CB governor. 

In the first quarter of 2019, the economy shrank 2.3 percent, decreased another 1.6 percent in the second quarter. Then the economy grew 1 percent in the third quarter. The last quarter growth was 6 percent. It was noteworthy that 3.8 points of this growth came from private consumption while 8.4 points came from stock increase.  

There was an economic administration that swept problems under the carpet for a while when there was a segment of companies surviving by rolling over debts and restructuring loans in an environment of weak growth.

After the dismissal of the governor of CB at the beginning of July 2019, what was expected happened in politics. 

Murat Uysal who was appointed in place of Çetinkaya, and his team immediately started block interest rate reductions. In the very next meeting, they cut rates 4.25 points from 24 percent. By the end of the year, the rate was half, down to 12 percent. This continued, and in May 2020, with the last cuts, interest rates were down at 8.25 percent. While there was a reduction of more than 15 points in one year, the profit of the Central Bank was backdated and transferred to the general budget. With a new arrangement, the contingency reserve was transferred to the Treasury. At the same time, the budget deficit was deepening notably. 

The budget deficit that was 56 billion Turkish Liras at the end of May 2018 tripled to 146 billion liras in May 2020. The contingency reserves taken from the CB and the annual profit that would all roughly correspond to a nearly 100 billion should also be considered.  

What is interesting is while these interest rates that are one of the basic parameters of economy are being cut with this speed, the discourse of “interest rates are down but nothing has happened to the forex rate” could find its way into the pro-government media. As a matter of fact, foreign currency sales from public banks continued with the same speed while these foreign currencies were drawn from the Central Bank reserves. The erosion that occurred was trying to be covered with swaps from banks, Qatar and China Central Banks, and these foreign currencies were presented as if they had “not eroded.”  

The Covid-19 pandemic caused foreign investors to accelerate their withdrawal of their foreign currencies from investments. Residents also withdrew from their foreign currency accounts from the system while buying gold on the other hand. Only after the Covid-19 pandemic, the foreign currency reserves of the Central Bank eroded about 31.5 billion dollars as of the end of June. Except that, with the 10-billion-dollar swap transaction with Qatar Central Bank, this figure looks as if it is 21.5 billion dollars.   

Naturally, the erosion of forex reserves of the Central Bank has triggered the questioning of the reliability of forex reserves.  

This time, calculations were done as such: At the end of June, gross forex reserve is 51.4 billion dollars. The gold reserve is 38.8 billion dollars. So, this makes a total reserve of 90.2 billion dollars. 

At the end of May, while there was a forex reserve of 54.3 billion dollars, according to swap data issued by the bank, 16 billion dollars of this total were from swaps with Qatari and China central banks, and 35.8 billion dollars were from swaps with banks. 

In other words, almost all of the forex reserves have been provided through swaps. If banks demand their foreign currencies then there will be no reserves left except for gold.

In short, if the CB had not swapped by saying “here is Turkish Lira for you, lend me foreign currency,” then we would have seen that almost all reserves had eroded except for gold. 

Well, where did this foreign currency demand come from that these reserves were eroding? How come those whose jobs are to manage the economy can still come out and talk about “the games of foreign powers?”  

From the beginning of the year to the end of June, the amount of securities foreigners have sold has reached 11.5 billion dollars and the amount of foreign currency residents have bought from banks has reached 7.5 billion dollars. There is no surprise when it is taken into consideration that this foreign currency demand was met with public banks selling foreign currency from their “back doors.”  

With the transition to the presidential system and in its follow up, the abrupt halt strengthened with rapidly dropping interest rates and monetization and foreign currency exit continued.   

Negative real interest and gigantic credit expansion 

Ankara is continuously explaining to the public, “the work of the foreigners to collapse the economy.” This seems to be the only thing Ankara knows while it demonstrates a bad management, not knowing what to do, continuously introducing bans, restrictions and heavy transaction taxes that damage the convertibility of the lira. It is an attempt to find a solution to the issues by locking free market rules and conditions, by threatening corporations and companies by using the power of the government. Some of these may look as if they are effective for a short period from time to time but this policy is one that nourishes fragility and deepens the crisis. 

Well, then, why do the resident citizens and companies opt for foreign currency? The answer is simple: It is because of the distrust of the government that demonstrates unlawfulness, arbitrariness, heavy pressure and distancing from democratic values, and distrust of the system this government has established. It is because of the Turkish Lira yields that have gone back to the level of negative real interest with the rapidly lowered interest rates.  

Along with the rate cuts, there is a gigantic loan expansion in a very short period, unseen in the past 10 years.  

After the pandemic, the “active ratio” practice that was introduced by the Banking Regulation and Supervision Agency (BDDK) to force banks for credit expansion has also pulled down real returns. Banks disliked credit expansion which caused them to opt for decreasing deposits by cutting deposit interest rates so that they can meet the active ratio, thus pulling interest rates below the inflation rate.  

While public banks have gone into record credit expansion, private and foreign banks showed a much slower rise.

If we consider that the beginning of the pandemic period in Turkey is the week of March 6, then 16 weeks from that date to June 26, lira loans have increased 351 billion Turkish Liras with a 20 percent rise; 66 percent of which was provided by public banks. The three major public banks correspond to 36 percent in the total banking system according to their size of assets.   

From the renewed elections in June 2019 until today, the lira credit expansion has risen 39.4 percent. This is a very high rate of increase while the share of public banks in this is also high, with 65 percent. 

Chemistry of economy has changed 

The trend that started just before the presidential elections in 2018 and accelerated after the elections changed the chemistry of the economy in Turkey. Private sector in Turkey was “handcuffed” in every aspect. From pricing to sourcing, to investment licenses, all regulatory higher bodies worked to make the entrepreneurs feel that “the party state” is watching them at every step.  

State-owned banks became more dominant. On one hand they used CB reserves and they opened positions (in 2020, 6.5 billion dollars in six months) steering the forex policies. On the other hand, while only 37 percent of lira loans at the beginning of 2018 belonged to public banks, at the end of June 2020 this figure reached 50 percent.  

In a repressed economy, a high loan injection without solving main structural problems is like injecting adrenaline to a coma patient, which may create some movement for a short while, but without continuity it may only help increase the number of “zombie” firms. In a country where there is a sharp drop in export orders and almost a total loss in tourism figures because of the pandemic - also considering that investments have ceased - where would credit expansion go?   

We will see in coming days what kind of an effect this extraordinary high credit expansion will have on prices. For a country that has foreign currency debts and weak foreign currency inputs, it is obvious it will exert pressure on the forex rate. A good example of this is 2017 when high credit expansion was achieved with the Credit Guarantee Fund (KGF) credits. As a result, the platform was prepared for a depreciation in Turkish Lira.

For the moment, only from tourism, with the best possible scenario a 25-billion-dollar loss is seen on the horizon. Also, with a drop in export orders which corresponds to a 10 percent loss (IMF estimate is 10 percent shrinkage in the Eurozone), possibly an approximately 15 billion dollars will also be added to the loss. April and May show us that losses in exports are much higher than imports; even though the volume is getting smaller, the foreign trade deficit is growing. There is an attempt to prevent this by imposing additional customs tax on thousands of imported goods. 

An economy management that has responded to the foreign demand shock by carrying the interest rate cuts to the negative field and by a gigantic credit expansion, most probably does not know what it is doing. The price of this adventurous economic policy that does not have any macroeconomic framework will be paid by residents. 

It is not too difficult to estimate the end of the adventurous economy that Ankara has been engaged in with the fear of losing power, but it is not possible not to wonder what its dimensions of damage will be.