Economic policy

Turkey’s heterodox economic policy requires more foreign funding

In less than a year, parliamentary and presidential elections will take place in Turkey. Nevertheless, this time the odds will be very different for the ruling Justice and Development Party. Current economic indicators do not favor the government of Recep Tayyip Erdogan due to soaring inflation and the dramatic depreciation of the Turkish Lira. The inflation rate was 79.6% in July 2022 and the Turkish lira has been in free fall since November 2021. Naturally, polls show that the main issue on the agenda of Turkish voters is the current economic situation (Hurriyet22nd of July).

One of the main reasons for the current negative outlook for the Turkish economy is the deterioration of global economic balances in the post-pandemic period. Coupled with regional crises, such as the war in Ukraine, commodity prices have risen and increased the burden on national economies. Beyond these factors, double-digit inflation in Western economies has prompted a shift to orthodox monetary policies by most central banks. In this regard, the decision of the US Federal Reserve to raise the interest rate consecutively for four cycles since March 2022, from 0.25% to 2.5%, has strengthened the US dollar against other currencies.

The repercussions of these developments have weighed heavily on the Turkish economy. Ankara has moved to promote the economy’s growth rates and exports under the label “New Turkish Economic Model” in the post-COVID-19 era. The main objective of this model was presented as solving the problem of chronic account deficit in the Turkish economy while promoting production and employment. The cost of this model would simply be the depreciation of the Turkish Lira. At the same time, the Central Bank of the Republic of Turkey (CBRT) gradually lowered the policy rate (one-week repurchase auction rate) from 19% in August 2021 to 14% in December 2021 in the hope of reducing the cost of borrowing. Subsequently, Turkey faced a monetary shock. The depreciation of the Turkish lira was so rapid that the power parity plunged from 9 lira to the US dollar to 18 lira in two months.

Reactively, the Erdogan government took a heterodox approach and developed alternative instruments to prevent further depreciation of the lira (Club Valdai, 3rd of March). Despite the intervention of the CBRT, the parity rebounded to 18 lira per dollar in August 2022. Moreover, the inflation rate swelled to 80%, while the current account deficit problem persists and increased to $32 billion in the first half of this year.

Yet, despite negative indicators in the monetary sphere, the Turkish economy has been growing for seven quarters since the second half of 2020. If we look at the performance of Turkish companies, they outperformed in the second quarter of 2022 taking advantage of the current economic environment. (Turkey, August 17). It seems that the current model favors economic growth. Yet, without structural reforms, growth hardly translates into well-being or economic transformation in emerging sectors. Overall, the terms of trade have deteriorated despite the expectations of the new economic program. In other words, Turkish exports are increasing in nominal terms, but their share in foreign trade continues to decline.

Seeking to protect themselves from the high inflationary environment, Turkish households are opting to maintain their savings in foreign currencies. This increases the demand for US dollars and euros at the expense of the national currency, which is known as “dollarization”. Despite new instruments introduced by the government, such as exchange-protected pound deposits, it is difficult to speak of a permanent reversal of dollarization. After peaking in December 2021, foreign currency deposits increased from $232 billion to $213 billion in February 2022. However, this trend reversed after April and reached $218 billion again in August 2022.

Coupled with the growing problem of account deficit, dollarization leads to a continuous depreciation of the Turkish lira. The CBRT is actively using its reserves to try to prevent further depreciation. On November 9, 2021, gross reserves were equal to $128 billion but depleted by $19 billion in two months. The downward trend shows that the CBRT continues to use its reserves to defend the lira against further depreciation, even after the monetary shock of December 2021.

Nevertheless, the downward trend has relatively reversed after plunging to $98 billion in July 2022. Reserves quickly recovered within two weeks and reached $113 billion on August 12. Economists, such as Uğur Gürses, claim that this increase is mainly related to incoming Russian funds for Türkiye under the Akkuyu nuclear power plant project (T24, August 8). Recently, it was also reported that Akkuyu’s largest shareholder, Rosatom, had raised an estimated $6.1 billion and pledged “Turkish dollar bonds to secure the line of credit” (Middle Eastern EyeJuly 30).

In fact, Ankara is expecting an additional $55 billion in funds from Saudi Arabia, Qatar, the United Arab Emirates and Russia (Yetkin Report, August 15th). The estimated value of Russian funds, linked to the Akkuyu project, is between 2.1 and 7.5 billion dollars. Indeed, somehow, Türkiye received a decent amount of funding in August to supplement Akkuyu’s funds. The $15 billion increase in reserves, since the end of July 2022, indicates that Turkey has managed to attract more funds from elsewhere.

On August 18, the CBRT lowered the policy rate by 100 basis points to 13%. Such a decision reflects that the Turkish government will not compromise on its heterodox policies despite the adverse indicators. Nevertheless, the sustainability of this policy depends on financing the needs of the Turkish Ministry of Treasury and Finance by printing more money or borrowing abroad.

Since the pandemic, the money supply has steadily increased alongside expansionary policies. Moreover, the monetary shock of December 2021 shows that the economy can easily slide into another crash. Despite the floating exchange rate regime, the CBRT tries to prevent this scenario by actively using its reserves and releasing pressure on the markets. The sustainability of this strategy is questionable, but before the next elections, austerity policies will be more risky for the popularity of the government.

Thus, the above scheme requires borrowing money from abroad to refine the instruments. Acquiring funds from conventional mechanisms is too costly given Turkey’s current credit default swap premiums. Rather than seek funding from traditional sources, the Turkish government is instead pushing political channels. Recently, Russia seems to have played a crucial role in injecting money into the Turkish system. Pursuing a policy of normalization with the Persian Gulf states, Ankara is also trying to attract more funds from the region. Clearly, risks in commodity markets persist as the Ukrainian conflict continues. So getting more funds from abroad is more critical than ever as elections loom for Erdogan and his government.