It has been two months since Turkey’s new economic team took over and some progress has been made. Under the new minister of treasury and finance, Mehmet Şimşek, and the new governor of the Central Bank of the Republic of Turkey (CBRT), Gaye Erkan, market normalization has begun and the risk of a balance-of-payments crisis has been reduced. At the same time, however, inflation is gaining new momentum, the budget deficit is sharply worsening, and no reform agenda has yet been announced to tackle these threats. Apart from perennial pessimists who point to President Recep Tayyip Erdoğan’s continued tenure in office and undaunted optimists who highlight the credibility of the new officials, no one really knows if the new economic team and its approach will prove successful in the near to medium term. Although two months is a short time to reach conclusions, the actions taken so far can still provide some insights.
Rate hikes and credit cap changes
The CBRT initially hiked the main policy rate by 650 basis points (bps) to 15% in June and then raised it by another 250 bps to 17.50% at its last meeting in July. More hikes are expected and will probably be delivered in smaller increments. However, the terminal rate, or long-term interest rate target, may be a disappointment for market participants expecting the bank to tackle rising inflation with positive real interest rates. A terminal policy rate of between 20% and 25% is likely. In the event of unexpected financial turmoil, the upper band could be raised to 25-30%; President Erdoğan and CBRT Governor Erkan implicitly closed the door to further hikes though. Erkan, who gave an impressive performance in her first official press conference for the quarterly inflation report released at the end of July, was glad to stop the recent increase in deposit rates, a critical barrier to curb the shift to non-lira-denominated assets.
Instead of applying a more conventional interest rate policy, the focus is on trying to gain more credibility by making new appointments to the CBRT’s top management. Three new deputy governors, all of whom are well-educated and one of whom has even worked for the U.S. Federal Reserve, were appointed at the end of last month. In addition to the interest rate tool, credit policy has also been significantly revised by simplifying regulations for banks and partially liberalizing the interest rates they can charge to their clients. With the cooperation of the CBRT and the Banking Regulation and Supervision Agency (BRSA), the Turkish banking regulatory authority, the cap on interest rates for commercial loans has been raised from 29% to nearly 38%. Loans for small and medium-sized enterprises, farmers, exporters, and entrepreneurs for new investment facilities are capped at 30%. Consumer loans are already hovering at around 50%, while mortgage rates are lower, but their loan sizes are very small compared to house prices. All of these caps will be revised slightly upward when more policy rate hikes are delivered.
The impact of all of this is likely to be mixed. On the one hand, loans are undisputedly more expensive than they were before the May 2023 elections. However, with the new caps, credit rationing among the private banks may end, and an increase in lending could undermine the promised contractionary monetary policy aimed at fighting inflation. On the other hand, government bond yields are still as low as 15-20% and there is less possibility of normalization for the bond market as the budget deficit is skyrocketing. New hikes in policy rates may push them slightly above the 20% threshold, but rates in line with inflationary expectations are not likely as the upcoming local elections in March 2024 will require more deficit spending to support populist promises and government mega-projects.
Inflation ramps up
There is one additional — and more dangerous — challenge for the rate hike policy as well: A new wave of inflation has just begun. At the end of July, the CBRT dramatically revised its year-end forecast for inflation to 58%, up sharply from 22.3% just three months earlier. According to the central bank, inflation will peak at nearly 70% in the first half of 2024, after the local elections. Unfortunately, despite the dramatic revision, these forecasts are still too optimistic. The monthly consumer price index increased by 9.5% in July and annual inflation shot up from 38.2% to 47.8% in a single month. There is more upward pressure due to unexpectedly high pay rises and a severe foreign exchange (FX) pass-through effect — the effect of changes in the exchange rate on the country's domestic prices for traded and non-traded goods. The current wave of rising inflation may exceed the previous peaks, which hit 25.2% in October 2018 and 85.5% in October 2022, and it is possible inflation could reach the triple digits by May 2024.
Fiscal policy moves
Although monetary policy is in the headlines owing to Erdoğan’s peculiar approach to interest rates, Turkish fiscal policy is also very effective and deserves closer examination. Populist economic promises, continuous support for business owners, inefficient and wasteful mega-projects, and foreign currency-denominated government bonds have been causing a massive deterioration in the country’s budget deficit. As a result of costs related to the twin earthquakes of February 2023, a budget deficit of 10% of GDP was possible for the 2023 fiscal year. To slow down the exponential rise of public debt, additional tax hikes were implemented in a supplementary budget draft in July 2023, alongside $42 billion in new government spending for the remainder of the year. The corporate tax rate was raised by 5%, reaching 30% for financial institutions and 25% for companies in other sectors. The value-added tax was also raised by 2%, to 20% for goods and services. A kind of wealth tax for motor vehicles was doubled for 2023 as well, as a temporary measure. The most painful hike though was the nearly 20% rise in the special consumption tax for gasoline and diesel. The rest of the spending will be financed by new debt and monetary expansion. More tax hikes may be enacted in December 2023 for the 2024 budget. Serious measures to rein in the budget deficit are needed, but they will probably be implemented after the 2024 local elections.
The tax hikes are an admission by the populist ruling party that its current policies are unsustainable ahead of critical elections that will determine control of Istanbul and other key cities. The CBRT’s sharp U-turn from its previous ultra-low interest rate policy is another indicator of this unsustainability. However, these new policies should not be viewed as a total change from the previous ones. Instead, the new economic management team is aiming to extend their use until the local elections. To reach this goal, some of the capital restrictions have been eased and a 35% devaluation of the local currency has been allowed. The credit default swap premium, a gauge of the risk that the country might prove unable to meet its hard currency obligations, declined rapidly from 700 bps to 390 bps thanks to these measures. The CBRT’s directly owned net gold and FX reserves increased from $-76.6 billion to $-60.4 billion.
Looking for cash abroad
With a new wave of inflation and an alarming budget deficit, this policy mix cannot be sustained until the elections without an external inflow of cash. So far the inflow to the stock market has totaled just $1.9 billion and there is no demand for government bonds as their yields are still extremely low compared with the realized, expected, and targeted inflation rates. For all these reasons new finance channels are necessary, and Erdoğan had started a rapid search for fresh funds from partner countries like Qatar, Saudi Arabia, the United Arab Emirates, and Russia. Turkey’s state natural gas importer, BOTAŞ, is still being supported by the postponement of its payments to Russia’s Gazprom. The UAE has promised to invest $50.7 billion in Turkish assets; the specifics of the plan have not been spelled out, but it will reportedly include $8.5 billion worth of offers for new Turkish dollar-denominated bonds. Turkey also signed a major drone deal with Saudi Arabia involving Baykar, a Turkish defense firm owned by the family of Erdoğan’s son-in-law; the deal is reportedly Turkey’s biggest defense contract to date and includes both joint production and technology transfer. Aside from rumors and limited media reports, no specifics about these deals have been released; however, the main expectation is that they will involve the sale of profitable assets owned by the Turkish state and private sector. In short, all of these attempts are designed to overcome the current foreign currency squeeze. The trade deficit remains a major problem though: Despite a reduction in June, when the current account recorded a rare surplus, it continues to deteriorate, with statistics for July indicating a $12.4 billion trade deficit following the sharp depreciation of the lira.
Turkey has been in an economic depression with a varying trajectory and degree of deterioration since March 2018. Erdoğan’s government has been successful at intervening to keep the economy afloat while postponing the cost of doing so until after the elections. But this approach of using unconventional methods that hamper the country’s long-term growth potential cannot continue forever. A stability program with or without International Monetary Fund support is likely after the local elections in March 2024, at which point a lower growth rate, higher unemployment rate, and widespread bankruptcy among private enterprises will become the new normal. These outcomes are certain, although the path to the upcoming elections and Erdoğan’s reaction to worsening economic conditions are hard to imagine. Despite the storm clouds on the horizon, the opposition parties are currently offering little alternative, seemingly paralyzed at a time when they could be very influential. Despite some early successes, Turkey’s new economic team faces major challenges and has a long and difficult road ahead of it.
M. Murat Kubilay is an independent financial advisor on the Turkish economy, a columnist in national media outlets in Turkey, and a Non-Resident Scholar with MEI’s Turkey Program.
Photo by Mustafa Kaya/Xinhua via Getty Images
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