Mehmet Şimşek who as the Minister for the Treasury and Finance heads the new economic team brought in by Turkish President Recep Tayyip Erdoğan following the presidential and parliamentary elections which were completed on May 28th, 2023, Following Şimşek’s appointment, Hafize Gaye Erkan was appointed as the new Governor of the Turkish Central Bank. Early statements by Şimşek indicated that he intended to return Turkey to an orthodox monetary policy whereby higher interest rates would be used as an instrument to bring the inflation rate under control.
Previously, the government believed that the best way to keep inflation under control was by alleviating the inflationary effects of a weakening Turkish lira through its liraization strategy. To this end, following the collapse of the Turkish lira towards the end of 2021, it introduced its new foreign exchange rate protected Turkish lira deposit scheme at the same time as selling foreign currency as necessary to support the Turkish lira. The result was that by the time of the elections at the end of May, the Turkish lira had become much overvalued, Turkish exporters were becoming increasingly agitated in the face of spiralling costs due to high inflation, the Central Bank’s net F/X reserves remained deep in the red, there was a mounting current account deficit, and the government was faced with a mountain of potential debt due to its guarantee of meeting negative F/X volatility on the F/X protected lira accounts.
The new economic team under Mehmet Şimşek allowed the Turkish lira to float at the beginning of June following the elections. The TL rate to the US dollar consequently fell from TL 20.69 from the end of May to TL 25.84 at the end of June, a fall of 25% in one month. The Turkish Central Bank hiked its policy interest rate from 8.5% to 15%. Everything appeared to be moving according to the plan to return to orthodox monetary policies. Indeed, gross reserves increase 11.8% to USD 108.6 billion at the end of June. To ensure that fiscal finances would be kept under control, a range of tax increases were introduced on July 7th.
It was during the month of July however that the Turkish government appeared to be having some second thoughts about the implementation of its new policies. On July 20th, the Central Bank raised its policy interest rate only by 250 basis points to 17.5% contrary to higher market expectations in light of the official annual inflation rate for June being declared at 38.21%. There was little relaxation of capital controls on companies and banks. Indeed, the Central bank had reverted again to selling foreign currency to relieve the continued pressure on the Turkish lira. The result was that a ceiling of TL 27 to the US dollar was placed on the value of the Turkish lira which has been maintained ever since. The gross reserves increased only minimally in July by 2.8% to USD 111.6 billion.
Going into August, the new economic team seemed to realise that it needed to be seen to be taking a more realistic and determined approach to returning to its desired orthodox strategy. It had already increased its forecast for the 2023 yearend inflation rate from 22.3% to 58% on July 27th. To the surprise of pundits, the Central Bank hiked its policy rate by 750 basis points to 25%. This move was received positively by the markets and foreign financial institutions. In reality though, the interest rate was still well below the official annual inflation rate for July which was declared at 47.83%. Capital controls on companies and banks were still in place and sales of foreign currency continued to be needed to protect the Turkish lira despite the substantial interest rate increase.
The most critical impediment faced by the new economic team in its wish to return to orthodox policies is the alarming growth in foreign exchange-protected accounts (KKM) since they were introduced in December 2021 to halt the run on the Turkish lira at that time caused by reductions in the policy interest rate. This development is nothing less than a ticking time bomb which threatens to overwhelm the government’s attempt to bring its finances under control. Central to its aims is the return to a free market in which the Turkish lira is allowed to adopt it true market value. However, with the sword of Damocles in the shape of the KKM accounts hanging over its head, the new economic team is adverse to allowing the Turkish lira to lose any further significant value.
It is now clear that while keeping a tight reign over the value of the Turkish lira, the new economic team has decided to somehow rid itself of the instrument of KKM accounts and all their potential debt risks. On August 20th, the government announced that it wanted to phase out this instrument. It declared its wish for private banks to gradually convince depositors to convert their savings from KKM into normal lira accounts. To this end it said that it would introduce conversion targets where private banks will need to take on more government debt should they not meet these targets, much to the displeasure of the banks.
However, it is clear that it is going to be very difficult to reduce the balance of KKM accounts. Since August 20th until today, the outstanding balance has only fallen TL 75 billion to some TL 3.300 billion. At this rate of decrease, the new economic team does not have the time to maintain an overvalued Turkish lira which has been on hold at close to TL 27 to the US dollar for over one and a half months. There will soon be pressure from exporters who once again see their products losing competitiveness. Imports and thereby the foreign trade deficit will once again surge.
In order to precipitate a faster decline in KKM accounts, the Central Bank has today increased the reserve requirements that banks have to meet on KKM account balances with a maturity of less than six months by 10 points to 25%. The reasoning behind the selection of six months is that Turkey’s local elections will be at the end of March 2024, and that any debt issues should be addressed after this time when any bailouts due to unsurmountable debt can be addressed at that time.
The new economic team finds itself in a dire situation. Though it knows that it must bring back orthodox monetary policies if Turkey’s economy is to recover, the prospect of being overwhelmed by a tsunami of KKM account debt payments is forcing the team to continue with policies it knows are wrong and unsound in the long-term. It is no longer a matter of political pressure from the President Erdoğan, but a matter of financial survival for the economy. Turkey is caught between a hard place and a rock.