Turkey’s economy is being driven fast along a road towards an inevitable and now very visible dead-end. The Turkish government only hopes that a crash will be avoided before the elections on May 14th, and has no intention of correcting or better still reversing the direction of the economy until this gamble has been played out.
The gamble into which the Turkish government has entered was initiated by the Turkish President Tayyip Recep Erdoğan some years ago when he emphasised the need for growth and therefore a reduction in interest rates despite high inflation, a very unorthodox economic analytical approach. The initial reductions in interest rates from 19% to 14% towards the end of 2021 caused the Turkish lira to spiral out of control. This development was only contained when the Turkish Treasury announced the introduction on December 21st, 2021, of a new instrument, its F/X-protected TL deposit accounts, which caused the Turkish lira to gain in value from TL 13 to the USD dollar on December 21st from TL 17.50 on the previous day.
The Treasury’s new F/X-protected TL deposit accounts instrument proposed to make up for losses incurred by holders of Turkish lira deposits converted from foreign currency should the lira’s decline against hard currencies exceed bank interest rates. For example, if banks pay 15% for one-year lira deposits but the currency depreciates 20% against the dollar in the same period, the Treasury will pay deposit-holders the differential. The instrument will apply for individuals holding lira deposit accounts with maturities between three to 12 months. The minimum interest rate will be the central bank’s benchmark rate and no withholding tax will be implemented. The new instrument at first glance was a clear success and gained valuable time for the Turkish government. However, the Treasury was potentially taking on foreign-currency risk of 3.3 trillion liras (USD 253 billion) then deposited in retail banking accounts as of November 2021 month-end. If the lira depreciates beyond deposit rates, that would impose a burden on the budget, and if the Turkish Central Bank had to print money to make up the difference, then inflation would spike yet again.
The slide in the Turkish lira towards the end of 2021 resulted in a depreciation of the lira by 79.5% in 2021, and despite the positive effect of the F/X-protected TL deposits instrument, the lira depreciated 40.3% in 2022. The weakening in the value of the Turkish lira during 2021 and 2022 helped Turkish exports to flourish as they became cheaper to buy. Exports increased from USD 169,658 million in 2019 to USD 254,197 million in 2022. This development pleased the government which took credit for the growing foreign trade figures and the beneficial implication this had for the growth of the Turkish economy as a whole.
However, the collapse of the Turkish lira in 2021 set off a surge in inflation which has since continued to have had a debilitating effect on the living standards of the Turkish populace. With presidential and parliamentary elections planned for mid-2023, the Turkish government realised that it had to do something to reduce inflation to retain the support of the electorate. The official annual inflation rate had reached a high of 85.51% in October 2022, with the unofficial rate as calculated by the ENAG Inflation Research Group being 185.34%.
In order to help bring inflation under control, the government decided to concentrate its efforts on supporting the Turkish lira, since this would at least help stabilise the cost of imports, an important contributor towards overall inflation. To this end, the government has continued to use any foreign exchange income and reserves at its disposal.
The Turkish Treasury, with support from the Central Bank, has developed its “liraization” strategy to encourage the use of the Turkish lira within the Turkish economy and halt its slide towards “dollarization”. At the centre of this strategy was the F/X-protected TL deposits instrument which had been so effective in propping up the Turkish lira. The Treasury aimed to persuade corporations and individuals with bank deposits in hard currencies to switch to using this new instrument. The result was surprisingly successful. At the end of November 2021, a record high of 63% of all deposits with banks were foreign currency denominated. This fell by more than 20 percentage points to 42.5% by the end of February 2023.
As a part of the Treasury’s liraization strategy, the Turkish Central Bank, by implementing a combination of pressure on the banks, with capital controls on and incentives to corporations, has ensured a tight control over foreign currency movement. The first move in this direction was the decision on January 3rd, 2022 for all companies to deposit 25% of their export foreign exchange earnings with the Turkish Central Bank. This was increased to 40% on April 15th, 2022. In a surprise announcement on June 24th, 2022, Turkey’s Banking Regulation and Supervision Agency banned banks from issuing lira loans to companies holding foreign exchange worth more than TL 15 million (USD 910,000) if that amount exceeds 10% of their total assets or annual sale revenues. In an economy where few enterprises operate without using lira loans as operational capital or for export-oriented production, the move is effectively forcing companies to sell hard-currency holdings and become more liquid in Turkish lira.
The Central Bank also introduced two new incentives on 26th January, 2023. Firstly, it removed the upper interest limit to be applied by the banks to f/x protected Turkish lira deposit accounts, as long as the rate is not below the official policy repo interest rate. Previously, the interest rate applied by the banks could not be higher than 3 percentage points above the official policy repo interest rate. Secondly, it provided an incentive of up to 2% on the conversion into Turkish lira of foreign currency holdings held abroad by companies. Companies which have converted 40% of their export proceeds are now allowed to keep the remaining foreign currency proceeds in F/X-protected TL deposit accounts and based on this commitment, may apply for the 2% f/x conversion incentive.
The Treasury’s liraization strategy has for all appearances been very effective. The Turkish lira has only devalued some 6% from July 2022 to March 2023, resulting in a minimal potential cost of financing F/X-protected TL deposits. The official annual inflation rate has fallen from 85.51% in October 2022 to 50.51% in March 2023. Furthermore, the Central Bank has also in the meantime managed to reduce its repo policy rate down to 8.5% from 14% between August 2022 and February 2023 without any resulting significant pressure on the Turkish lira.
However, it has been claimed that the government’s liraization strategy was not in fact influential in the stabilisation of the Turkish lira since July 2022. Turkey’s net foreign currency reserves are significantly in the red, and the US Fed’s aggressive and fast hikes in its interest rate (9 increases from 0.25% to 5% between March 2022 and March 2023) has meant that international cash funds have become more scarce for emerging markets such as Turkey as they are drawn towards the US dollar. Turkey need new sources of funding if it is to maintain its current economic policies. Consequently, over the last year, Turkish President Erdoğan has in particular made great efforts to improve Turkey’s sour relationships with Arab countries such as Saudi Arabia, UAE and Egypt with an aim to procure financial support from the cash-rich Arab middle east region. Even ties with Israel have improved to gain that country’s support to develop energy resources. Cash loan infusions and swap agreements have been obtained from Saudi Arabia, UAE, Qatar and Russia. A life line has thus been thrown to Turkey for it to keep the Turkish lira in check at least until the May 14th elections.
If this indeed the case, there is every likelihood that the Turkish lira will slide yet again after the up-and-coming elections. There is already indications that the Turkish lira is under pressure. The gap between buying and selling rates at the banks is widening, indicating that the banks are adverse to selling foreign currency which is coming in short supply due to pressure from the Central bank. No doubt as a consequence of this, the buying and selling rates are now somewhat higher at the Kapalıçarşı (Grand Bazaar) F/X market in Istanbul as corporations and individuals look here for an alternative source of foreign currency. Another collapse in the Turkish lira after the elections will have a devastating effect on inflation, the economy and the already diminished living standards of the Turkish population.
The Turkish government has been plastering over holes in the roof ever since its stubborn reduction of interest rates in the latter half of 2021 which caused the Turkish lira to collapse and inflation to surge. Its use of the F/X-protected TL deposits instrument and any foreign currency funds it could get its hands on to support the Turkish lira can only be described as temporary patch-up jobs which have nothing to do with ensuring a sound and more productive economy in the long-term.
Furthermore, the liraization strategy has resulted in some new fundamental weaknesses and risks in the economy which are not being addressed. For example, though the stabilisation of the Turkish lira has also meant that there has been an equally minimal increase in the cost of imports, inflation, though gradually falling, is still over 50%, with the unofficial ENAG figure over 110%. Exporters are now in a difficult position as their profits from export revenue is now in danger of being eroded by the high increase in their material and labour input costs. The minimum wage was increased by 54.66% as of the beginning of 2023 and will be adjusted up further in the Summer months.
The foreign trade deficit for 2022 was USD 109,524 million compared with a deficit of USD 46,211 million in 2021. The foreign trade deficit for the first quarter of 2023 was USD 34,902 million. The negative effect on the current account deficit has also been significant with a deficit of USD 48,751 million in 2022 compared with a deficit of USD 7,232 in 2021. The current account deficit for the first two months of 2023 was USD 18,801 million. There is currently no indication as to how these growing deficits will be met.
GDP growth for Turkey was recorded at 5.6% in 2022 compared with 11.4% in 2021, and GDP growth in 2023 has been forecast at between 2.5% and 3%. The GDP increase of 5.6% for 2022 was led by higher consumer consumption (19.7%), with investment growth only at 2.8%. Indeed, GDP growth in Turkey has in recent years been led largely by government spending and consumer consumption. Growth had always been a key factor in President Erdoğan’s strategy for the Turkish economy, but it would appear that this has also been sacrificed for the May 14th elections.
In recent years, there has been a conspicuous lack of investment in industry, and foreign investors have also begun to keep their distance due to the lack of judicial independence, human rights, an independent central bank, and a coherent economic plan in Turkey.
Turkey’s monetary policy no longer follows an orthodox macro-economic norms, and indeed has been described as heterodoxical by the Turkish Minister of the Treasury. The reduction of interest rates at a time of high inflation, the introduction of F/X-protected TL deposits, direct involvement in the Central Bank’s policies, pressure applied on the banks’ F/X transaction activity, and capital controls on Turkish companies’ use of foreign currency, all add up to an economy model which leaves economists around the world in a state of awe and disbelief. It is as if monetary policy is made up on the spot as it is faced with each new challenge. The Central Bank’s current repo policy rate of 8.5% has become meaningless where annual inflation is over 50%, TL deposit interest rates are over 30% and loan interest rates are over 50%. We are left with a confusing scenario and no one has any idea how it will play out.
Unless something gives way in the meantime, the 14th May election date will be the signal for a long overdue correction in Turkey’s economic monetary policies. A combination of an overvalued Turkish lira, high inflation, negative net reserves, large current account deficits, negative real interest rates, and higher borrowing requirements cannot be maintained.