Steering Turkey towards a sustainable economic path will require a sharp rise in borrowing costs and a further lira depreciation, with the country’s foreign currency war chest “dangerously” depleted by unorthodox policies and at least $23bn used to prop up the lira before May’s election.
The financial leadership drafted in by Recep Tayyip Erdoğan since his re-election last month, led by recently appointed finance minister Mehmet Şimşek and new central bank governor Hafize Gaye Erkan, faces mounting challenges as they seek to pull the $900bn economy away from the brink.
There are expectations that interest rates will have to rise sharply, starting next week when the monetary policy committee meets with Erkan at the helm for the first time. This would reverse the low-rate policy pushed by Erdoğan, which is blamed for a severe cost of living crisis.
“[A turnround would] not be easy to achieve since recent economic policies created significant anomalies,” said a senior analyst at the Turkish branch of an international financial group. “Even if they want to return to orthodox policies, those steps may create side effects.”
Erdoğan’s flagship economic programme, focused on keeping borrowing costs low despite acute inflation and defending the lira, have caused severe imbalances and sent foreign capital fleeing.
The use of unconventional tools accelerated ahead of elections as Erdoğan deployed government resources to boost the economy, including giving away free gas and lifting the minimum wage. Some $23bn was also spent supporting the lira between the start of 2023 and May’s second-round elections, according to calculations by economist Haluk Bürümcekci, which exclude other interventions to help ease the currency’s fall in recent years.
Erich Arispe, the primary analyst responsible for Turkey’s government credit rating at Fitch Ratings, said: “The built-up of distortions and the increase in vulnerabilities as a result of the election stimulus may call for at least a tactical shift in terms of economic policy direction.”
Erdoğan said this week that while he had not changed his mind on the unorthodox view that high interest rates caused rather than cured inflation, he would allow Erkan and Şimşek to take steps to bring inflation to single digits from the current level close 40 per cent.
Şimşek, a former deputy prime minister well regarded by foreign investors who has vowed to restore “rational” policies in Turkey, has yet to disclose specific policy details. But analysts say the lira’s 16 per cent tumble against the dollar to new record lows since the May 28 vote was a sign that Turkey has begun intervening less aggressively in the currency market.
He has said his priorities include narrowing the country’s yawning current account deficit, which has been caused in large part because goods imports massively exceed exports. The deficit was $29.7bn in the year to April, the highest level on record.
A lira that remains overvalued even after falling 64 per cent over two years and an overheating domestic economy have been partly to blame. Gold purchases from abroad by locals fearing further currency falls have also fed the widening trade gap.
The current account deficit has been financed in large part through the central bank’s foreign currency reserves. Reserves had also been spent defending the lira, a policy that was “not sustainable”, said Clemens Grafe, an economist at Goldman Sachs.
Turkey’s official reserve assets amount to $99.8bn, including $50.3bn in foreign currencies and $42bn in gold, according to central bank data. But this does not include the amounts the central bank owes to locals and foreigners.
Net foreign assets, a proxy for foreign exchange reserves that is closely watched by investors, were minus $15.9bn, a figure that would be even lower if not for tens of billions of dollars of funds borrowed from the local banking system and foreign central banks through tools known as “swaps”.
Turkey’s net foreign assets are in an even worse position than after the 2000-01 Turkish banking crisis, during which the lira collapsed and interest rates soared, central bank data showed. “Current levels are dangerously low and it requires efforts to rebuild foreign currency reserves,” said Christian Wietoska, a Deutsche Bank strategist.
Economists expect several actions in quick succession will be needed to begin turning around the economy. “Stabilising the economy will require a large, and we think discontinuous, adjustment to the exchange rate,” Grafe said, adding that “a significant tightening of policy to slow domestic demand” was also needed to reduce the current account deficit.
Expectations vary for the June 22 rate decision, but several leading investment banks have said a rise from 8.5 per cent to 20 per cent or even higher is possible.
“We can talk about personalities, track record, the signals and speculation about what [the new team] can do. But what’s really important is the timing and sequencing of policy measures . . . because there are so many moving parts in this adjustment,” Arispe said.