On the road to a Turkish currency crisis

Despite his disastrous economic policies over the past few years, Turkey’s President Recep Tayyip Erdoğan appears to be well on the path to reelection. In last weekend’s first-round presidential election, Erdoğan gained just under 50 percent of the vote. He is now widely expected to win in the run-off election set to take place at the end of this month. This has to remind one of H.L. Menken’s cynical remark that democracy “is the theory that the common people know what they want and deserve to get it good and hard.”

Judging by Erdoğan’s comments on economic policy on the electoral trail, Turkey is likely to get more of the same highly unorthodox monetary policy that has produced unusually high inflation and depleted the country’s foreign exchange holdings. As he colorfully put it, “as long as this brother of yours is in this position, the interest will continue to fall.” This heightens the chances that Turkey will soon experience yet another burst in inflation and an economically damaging foreign exchange crisis.

To say that Erdoğan’s ideas on monetary policy place him off the reservation would be an understatement. Last year, when global inflation was on the rise and when every major central bank in the world shifted to a hawkish monetary policy stance to regain control, Erdoğan pressured the Turkish central bank to more than halve interest rates, from 19 percent to 8.5 percent. He did so in the misguided belief that far from being a cure for inflation, higher interest rates were the cause of inflation. Never mind that if ever there is one thing on which practically all economists can agree, it is that higher interest rates are an essential part of any policy package to regain inflation control.

The — predictable — consequences of Erdoğan’s policies were a collapse of the currency and a surge in inflation. The country’s currency has lost more than half of its value, plummeting from around 7.5 Turkish liras to the dollar in early 2021 to its present level of just under 20 liras to $1 USD. Meanwhile, inflation surged from 20 percent in early 2021 to a peak of almost 84 percent in September of 2022.

In the runup to the election, inflation was artificially suppressed to garner electoral support. However, it remained around 45 percent. The net consequence of these inflationary policies has been that literally millions of people have been thrown into poverty, as wages lagged considerably behind price increases.

President Erdoğan’s pigheadedness about the need for ever lower interest rates has also highly damaged the country’s external economic position. Under his watch, the Turkish central bank now has negative international reserves of around $70 billion. Those reserves plummeted in defense of the currency as both domestic and foreign investors headed for the door for fear of inflation and a lack of the rule of law. Meanwhile, the country’s external current account deficit has ballooned to around 6 percent of GDP. That is a dangerous level that in the past has presaged a currency crisis.

In the runup to the election, Turkey’s economy was kept afloat by extraordinary measures that will be difficult to sustain. Lira bank deposits were guaranteed against dollar depreciation by government promises to make up for any losses incurred on those accounts. At the same time, Turkey called on its allies, most notably Russia, to provide it with currency swaps.

Now that Erdoğan looks well on his way to another term, strong pressure is bound to build up that could lead to a full-blown Turkish currency crisis and capital controls — that is, unless Erdoğan has the good sense to abandon his half-baked ideas on interest rates and allow the Turkish central bank to return to orthodoxy. Judging by his past obstinacy, I would not advise betting the farm on such a policy U-turn before we have another Turkish exchange rate crisis and another inflationary surge.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.