Turkey’s economic policy deadlocked

The economic policy implemented under Turkish Treasury and Finance Minister Mehmet Şimşek has been deadlocked. What does this mean? It's like a locked steering wheel in a car, meaning that the car moves in a fixed direction, no matter what comes its way. If there is a locked economic policy, the policymakers hope that there is no object to crash into ahead. But, of course, the world is not going to wait for the outcome of your economic policy experiment. Therefore, the Şimşek administration's economic experiment is reaching dangerous points. Let me explain briefly.

The mechanisms

The primary objective of the economic policy implemented by the Şimşek administration was to eliminate the risk of a balance of payments crisis ahead of the 2023 elections. Increasing the reserves of the Central Bank of the Republic of Turkey became one of the primary objectives to mitigate this crisis risk. Interest rates were raised to achieve this goal.

Once there remains no risk of a balance of payments crisis by 2024, the priority was to fight inflation. Indeed, reducing inflation, which almost doubled a year after Şimşek took office and played an important role in the loss of the local elections, became the priority economic policy in 2024.

Interest rate hikes, which are used both to strengthen the Turkish Central Bank reserves and to fight inflation, interestingly lock economic policy or, in other words, remove the flexibility of economic policy.

There are two main mechanisms. First, an increase in the interest rate on Turkish Lira loans makes it cheaper to borrow in foreign currency, which in turn increases the share of foreign currency loans in total loans. Second, linking the fight against inflation to the real appreciation of the lira encourages foreign inflows by guaranteeing foreign investors a profit.

The outcome of these two mechanisms is the following. It is becoming increasingly difficult and costly for the Şimşek administration to cut interest rates in line with the soft landing scenario. However, a monetary policy 'stuck' at high interest rates increases the risk of economic slowdown and even crisis.

Foreign Currency Debt Grows

Let's start with the first mechanism. What is wrong with borrowing in foreign currency? We saw the problem in the 2018 currency crisis. In 2009, when Ali Babacan was at the helm of the economy, a regulation liberalized foreign currency loans and the private sector's foreign currency debt increased exponentially. However, when the lira devalued sharply during the 2018 currency crisis, the balance sheets of firms with foreign currency debt were severely damaged, leading to the bankruptcy of many firms. Those that were 'too big to fail' went into debt restructuring, as the inability of these large firms to repay their debts began to put the banking system under strain.

Although borrowing in foreign currency was restricted in 2018, the widening gap between lira interest rates and foreign currency rates after 2023 to the detriment of lira loans encouraged firms that could borrow in foreign currency to use this cheaper financing facility. However, the increase in foreign currency loans makes the start of interest rate cuts increasingly costly.

Valuable Lira

The second mechanism that locks economic policy is the Şimşek administration's attribution of disinflation to the appreciation of the lira in real terms. According to this approach, since the production structure is dependent on imports, import prices can be seen as an important factor in the formation of domestic prices. Therefore, since the appreciation of the lira will make imports cheaper, it will be possible to control domestic prices.

It is true that import prices have an impact on inflation. The most concrete example is the devaluation of the lira in the fall of 2021 or the summer of 2023, and its return as inflation in the months immediately following. However, there is an interesting situation in Turkey. Although the lira has appreciated in real terms and real wages have fallen since 2023, the decline in inflation has not yet materialized, not counting the base effect. The main problem here is that the economic administration ignores the inflation dynamic driven by corporate profits. Therefore, despite the real appreciation of the Turkish lira and the suppression of wages, inflation remains rigid.

The cheapening of import prices to reduce inflation is achieved by attracting capital inflows through a high interest rate policy. In other words, according to this approach, capital inflows are necessary to contain domestic price increases and interest rates must be kept high to do so. However, as long as the real appreciation of the lira is declared as one of the main ways to reduce inflation, investing in the Turkish lira means a risk-free return for foreign funds, i.e. a guarantee of profit.

Deadlocked Economic Policy

Last week, I pointed out the current crisis dynamics in the Turkish economy. The most important feature of the current crisis dynamics is that they are the result of the implementation of the Şimşek program. Rising unemployment, slowing industry, falling capacity utilization, and declining confidence in the economy all point to a looming recession.

Can the Central Bank cut interest rates against these crisis tendencies? At a time when it is interest rate cut season in the world? As we can see from yesterday's central bank interest rate decision (keeping interest rates unchanged at 50 percent), this will not be easy.

The deadlocked economic policy under Şimşek's coordination, i.e. the loss of flexibility, makes the Central Bank’s possible steps to avoid a 'hard landing', i.e. a crisis scenario, increasingly costly.

However, in recent weeks, the Central Bank officials have made statements suggesting that even a 'hard landing', i.e. an economic crisis, may be necessary to bring down inflation. However, I would like to emphasize that interest rate cuts are unlikely to be implemented in the short term due to the inflexibility of economic policy, even if the economic administration wants to do so. Because, in this case, the possible devaluation of the lira will cause damage to the balance sheets of foreign currency borrowers and trigger the exit of the capital that has entered with great speed, which will bring us back to where we started. In short, the Şimşek administration's economic policy experiment has taken on a dangerous dimension.