Central banks around the world are currently witnessing unprecedented rates of inflation for more than 20 years. Supply chain issues and labor shortages resulting from the pandemic, combined with soaring food and energy prices, have pushed up prices by the same amount. 6.2% in the USA, 4.2% UK, 10.7% in Brazil and 4.5% in India. Every central bank has responded by raising interest rates or committing to raise them in the immediate future.

It is too early to tell if the novel coronavirus variant B.1.1.529, first identified in Botswana, will take rate hikes off the agenda, but they are certainly not part of Turkey’s plans. Since September, Turkey has cut interest rates by four percentage points from 19% to 15%, wreaking havoc on financial markets.

The Turkish lira, which traded at 8.28 TL = US $ 1.00 in early September, fell to 13.40 TL a few days ago, its lowest level on record at the end of an eleven streak. days of consecutive defeats. It is now trading around 12.10 TL, having recovered slightly but weakening again as investors withdraw money from weaker currencies in response to new fears about COVID.

So why did Turkey have such an “irrational” political stance on interest rates when everyone else is doing the opposite?

Erdoğanonomy

It would have been of some academic interest to analyze the reasoning behind such a move, but there has been little on the part of the authorities – except to say that it “would stimulate exports, investment and employment”. President Erdoğan believes that a rise in interest rates would increase inflation rather than reduce it, and has maintained this view throughout the nearly 20 years he was Prime Minister (2003-14) and President ( 2014 to present). Unlike the 2018 currency crisis, which followed a diplomatic crisis between Turkey and the United States, the latest debacle is largely artisanal and self-inflicted.

Turkish lira against US dollar

There have been two important changes in governance in recent years with important consequences. First, the transition to the current executive presidential regime in 2018 officially crowned the president as the dominant authority in all policy areas.

Second, the independence of the country’s central bank, granted as part of a series of economic reforms in the early 2000s before Erdoğan’s AKP came to power, is now also a thing of the past. There have been four central bank governors in less than three years, with a clear pattern of layoffs closely following interest rate hikes. The most recent appointment was Şahap Kavcıoğlu in March, and interest rates have not risen since then.

Aggravating factors

Lira has now lost almost 40% of its value since the start of the year. This is a massive depreciation for any economy, and even worse for Turkey for various reasons. On the one hand, the fall in the lira will soon translate into higher inflation, already oscillating around 20% even through official accounts. The fact that a large part of the economy is based on U.S. dollars does not help.

Existing estimates suggest that a 10% depreciation of the lira against the US dollar causes inflation to rise by about two percentage points. Since inflation only rose by about a percentage point since the summer, this suggests that there is still a long way to go. About 70% of Turkey’s imports are raw materials and goods used in manufacturing, so this is where most of the effects will be felt. Among the difficulties there are Turkey must import most of its energy.

Another problem is that a significant portion of Turkey’s debt is denominated in foreign currencies – mostly US dollars and euros. The weaker pound makes it much harder to service these debts, and Turkey has to pay 168 billion US dollars (£ 126 billion) of its external debts over the next 12 months. The increased risk of default could inflict heavy losses on foreign investors, with some Spanish and Italian banks among those who are highly exposed. This raises the possibility that Turkey’s problems will spill over to other countries, and the decline in the pound is likely to worsen if the market panic continues due to the B.1.1.529 variant.

What can policy makers do?

In the face of currency turmoil, there are three policy tools available to policymakers: raising interest rates, selling foreign exchange reserves, and imposing capital controls (which means you are preventing currencies from leaving the country).

All three aim to ease the pressure on the national currency. Rising interest rates make the national currency more attractive to investors because it increases what they can get out of it. Selling foreign exchange reserves means buying more national currency, so its value is enhanced by the additional demand. And capital controls slow down the volume of trade between the national currency and the foreign currency, which means that fewer people sell the national currency.

Apart from the fact that the Turkish regime is not keen on raising interest rates, it cannot sell foreign exchange reserves because it does not have. This leaves capital controls, which would be an extreme measure in today’s world and would involve Turkey withdrawing from the international financial system. Capital controls are also difficult and expensive to operate, even in countries with strong institutions.

Maybe instead the central bank will reverse its policy and raise interest rates. This already happened during the 2018 currency crisis, when the authorities turned around and raised interest rates. by 6.25 percentage points this September. By that time, the pound had fallen to nearly 6.50 TL = US $ 1.00 – still much more valuable than it is today – before strengthening to 5 TL after the change from Politics. Likewise, in 2020, a string of rate cuts were followed by sharp rate hikes later in the year.

Yet, as necessary as it is for Turkey to raise interest rates, it will do little to resolve the large imbalances in the economy that have built up over a long period of time.

What Turkey needs is a carefully designed and inclusive stabilization program with buy-in from broad sections of society, with central bank independence at its heart. This is highly unlikely to happen with the current almighty presidential regime, with or without a change of power.