Turkey’s Inflation Crisis

Is Erdogan’s autocracy leading Turkey to economic failure?

-Penned by Jeevan Joseph & Sakshi Sharma

It is no secret that the pandemic pushed many economies off the edge and that many of them are still in the phase of a long and arduous recovery. However, what makes the case of the Turkish economy unique is that its decline started even before the pandemic’s onset. Turkey had been grappling with tremendous amount of debt to the tune of 450 billion USD, a steadily depreciating currency (the Turkish Lira) and inflation which is at a staggering 21%.

The country is going through of a rough patch of inflation as prices of essentials like medicine, sanitary goods, fuel and groceries are climbing sky high. The country is also said to be experiencing high rates of inflation since 2018. To understand the root cause of the problem, we have to turn to the macroeconomic relationship between interest rates and inflation. Put simply, when the general level of income rises, people are left with more money. As an increasing amount of money chases the same basket of goods, the price of these goods increase. Therefore, inflation, which is defined as the rate of increase of prices, shoots upwards.

Usually, most central banks increase the interest rate in the country to combat inflation. When interest rates increase, people are incentivised to save due to the possibility of higher returns. This reduces the amount of money in the economy that fights for the same basket of goods. Therefore, the end result of this intervention is a dip in the inflation numbers. However, under Erdogan, Turkey has lowered interest rates, which is contrary to the above stated economic wisdom. Erdogan is reportedly uninterested in heeding to the advice of experts in reviving the economy. Infact, he has fired top officials like the finance minister Nureddin Nebati and two deputy governors of the central bank who challenged his position on lowering interest rates.

During his tenure, Erdogan has emphasised on the importance of growth by spending on infrastructure projects, opening opportunities for foreign investment and encouraged debt fuelled expansion of consumer consumption. Erdogan’s rationale behind the reduction of interest rates is the fact that it helps spur growth. The interplay of interest rate and growth is fairly simple. With a lower interest rate, financing costs reduce and in turn induces greater borrowing and investing patterns. However, Erdogan appears to be oblivious to the dark side of this policy. If interest rates are much below the optimal level, it may lead to excessive growth and inflation.

The fall of the Lira by nearly 100% of its pre-2021 value is a major of concern for the country. Many Turkish businesses that have borrowed money from abroad and must repay their debt in dollars now face the bleak prospect of a bankruptcy owing to this massive fluctuation in exchange rates. Imported goods, including essentials, have become more costly owing to the steep decline in the Lira’s value. The currency depreciation adds to the problems created by Erdogan’s interest rate policy. The lower interest rates drive inflation, which in turn leads to a vicious cycle of currency depreciation which again leads to inflation. Some of the reasons for this phenomenon include:

‘Imported Inflation’: A rise in the price of imported goods because we need to spend more Lira to buy goods that are quoted in Dollars.
Higher domestic demand: The demand for imported goods falls due to their higher prices. This forces consumers to prefer domestic goods. This leads to an increase in aggregate domestic demand. The inflation caused due to this mechanism is called the demand-pull inflation.

With inflation reaching an all-time high, should Turkey’s Central Bank (TMCB) keep supporting Erdogan’s policy or is it finally time for reversal? Well, TMCB isn’t faced with this question for the first time. Back in 2018, when the inflation rate sky rocketed to 25.24%, the TMCB went against the president’s autocratic will, exercising its power and increasing the one week repo rate to 24%. The result of the tightening of the monetary policy was a reduction in inflation rate from 25.24% in October 2018 to 8.55% in October 2019. However, the reduction cost the then governor and his supporters their jobs, which partly explains why the TMBC is so reluctant to go against the president’s ill-conceived logic.

There is a faction that believes the TMBC should continue supporting the president. The supporters believe that the Islamic-riba-based actions are helping the country reduce its current account deficits. Current account deficit means exports, receipts of transfer payments etc. are less then imports, payment of transfers, etc. The deficit in this account is financed by sale of foreign exchange reserves or through foreign borrowing. To understand the economics behind the low interest rate policy, it is important to understand Turkey’s past financial position.

Turkey had a current account deficit for a long period of time, which was primarily financed via foreign borrowing. With the current global liquidity conditions and the country’s geopolitical position, the continuation of the lending seemed unlikely. In the face of this adversity, Turkey was left with two choices

Hike interest rates in comparison to the world interest rates, leading to high capital inflows in the country.
End the need for financing by reducing the current account deficit. This, though, comes at the cost of depreciating the Turkish Lira.

It is no surprise which option President Recep picked. The results, though, are worth looking at. Turkey has been able to maintain a current account surplus for the last three months. Tayyip’s supporters believe that if the surplus can be maintained along with high investment rates and increasing tourism revenues, then the sentiment for Turkey in the global financial market will change drastically, leading to reversal of the country’s current economic position. The proponents of this theory are very few in number.

Economic logic forces us to support the first stance, which highlights the urgent need to raise interest rates. A series of changes need to be made including the restoration of TMBC independence and credibility, increasing public confidence in Lira, etc. Perhaps, the country can emulate Mexico as it has managed to keep the inflation rate low since early 2000s through inflation targeting. After the 1995 crisis, Mexico reduced inflation from 52% to 4% in 2003 through implementation of sound fiscal policies, which were complemented by a gradual shift to the inflation targeting system.

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