Is Turkey heading for a monetary policy U-turn?

When the Turkish Central Bank meets this Thursday, it will not just attract domestic attention. The international financial and foreign exchange markets have their eyes locked on the country as they eagerly await confirmation that Turkey's monetary and fiscal policy makers are indeed coming to their senses.

Since President Recep Tayyip Erdogan brought former finance minister and Merrill Lynch banker Mehmet Simsek back into the cabinet, and with US banker Hafize Gaye Erkan as the new head of Turkey's central bank, there have been increasing signs that Erdogan has finally given the green light for a policy turnaround.

The reelected president had repeatedly hinted at the prospect of a change of direction in recent days. But international investors' mistrust of Erdogan's wayward economic and financial policies runs deep. Emerging markets expert Timothy Ash of BlueBay Asset Management in London, who has covered Turkey extensively for years, summed up the difficult task for Simsek, Erkan and their cohorts:

"Simsek, Erkan and their team have kept quiet since their appointment," he wrote in a tweet in mid-June. "I understand they have a big job to do to find out how bad things are (to find out where the bodies are hidden in the basement). But I think that soon they will have to approach the financial markets and inform them. What's the plan? Is June 22 the crucial day?"

Turkey's economy: 15 years wasted?

For years, the Turkish economy has been in perpetual crisis. Massive inflation of nearly 40% (as of May 2023) has eaten away at the purchasing power of the Turkish people. In some places, the inflation rate skyrocketed to over 80% in 2022. And these are the figures from the government statistics, which many experts eye with suspicion.

The country, which is poor in raw materials, traditionally imports many more goods than it exports, and therefore suffers from a high current account deficit. Turkey's current external financing needs are estimated at more than $200 billion (€183 billion). At the same time, the national debt is growing: In the first four months alone, the public budget deficit exploded by 1,870% year-on-year, according to calculations by Turkish economist Tahsin Bakirtas. Private households are also heavily indebted at a rate of around 180% of Turkey's gross domestic product (GDP).

Today, the national currency is a mere shadow of its former self. Whereas one lira cost just under €0.60 at the beginning of 2008, the current exchange rate of €0.04 is less than half a euro cent. And due to the dramatic currency decline, the cost of importing raw materials and goods continues to rise.

Instead of using interest rate hikes to curb inflation, as central banks around the globe do, Erdogan, who describes himself as an "enemy of interest rates," has used political pressure on central bankers to keep interest rates low for years, shattering state finances along the way.

Meanwhile, the Turkish state has struggled to stay afloat: Its foreign exchange reserves are almost exhausted. This year alone, the central bank has burned through around $25 billion to finance the huge account deficit and support the weak lira. Loans are now largely supplied by banks from Islamic countries, such as the United Arab Emirates (UAE). At the same time, Turkey, which suffers from a shortage of foreign currency, has shuffled from crisis to crisis, carried along by financial injections and credit boosts from friendly regimes such as Qatar and Russia.

Dependence on rich Gulf states grows

Just two banks from the UAE — Abu Dhabi Commercial Bank (ADCB) and the state-owned Emirates NBD bank from Dubai — recently provided Turkish banks with more than half of urgently needed loans, according to a report by Bloomberg News. According to the report, Western banks such as the Dutch bank ING or Germany's Deutsche Bank have almost halved their involvement in joint loans from foreign banks, so-called syndicated loans, compared with the previous year.

Banks from the rich Gulf states, on the other hand, have quadrupled their exposure over the same period. In addition, currency transactions, known as currency swap agreements, to the tune of around $20 billion have been concluded with the UAE and Qatar in recent years to replenish the Turkish Central Bank's nearly depleted foreign currency holdings.

How serious is Erdogan?

Economists at JPMorgan expect Turkey's central bank to nearly triple its current key interest rate of 8.5% at its next meeting. Rates are likely to be hiked to a handsome 25% on June 22, the US bankers wrote in a recent report. By the end of the year, the JPMorgan analysts even expect interest rates to reach 30%.

Turkey's new finance minister, Mehmet Simsek, whom Erdogan dismissed in 2018 over fiscal policy disagreements, announced a few days ago that his country would return to "rational fundamentals" in economic and fiscal policy. Erdogan even spoke recently of "quick measures."

"After our finance minister's deliberations, we accepted that he will take quick measures in consultation with the central bank," the president said last Wednesday on his return flight from a visit to Azerbaijan, Turkish media reported.

To political observers, Erdogan's words suggest that he has given his finance minister and new central bank chief the green light to raise interest rates.

Erdogan has repeatedly replaced the head of the central bank in recent years in order to implement his unorthodox policy of cheap money and low interest rates. Hafize Gaye Erkan is already the fifth central bank governor since 2019. But how determined is the former Goldman Sachs banker when it comes to walking Turkey back from a fiscal precipice? International investors and economists have repeatedly stressed that Turkey needs to do more than significantly raise interest rates to curb runaway inflation.

Old policy still at the ready

Erdogan's often surprising and domestically motivated measures are also keeping foreign investors on the sidelines. Short-term foreign exchange regulations and the obligation to do business in the local currency have destroyed a lot of confidence in Turkey as a business location. Major investments such as the construction of a large Volkswagen assembly plant have been on hold for years.

The new head of the central bank brings experience in risk management with her from the US. Most recently, the 44-year-old Erkan worked at the US regional bank First Republic, which has since been taken over by JPMorgan.

Erdogan wants to push inflation from its current level of around 40% down into the single digits. But he intends to stick to his policy of "low inflation and low interest rates."

"God willing, neither our finance minister nor our central bank governor will embarrass us," Erdogan said. "I think we will hopefully achieve positive results."

Foreign observers noted with interest that Erkan's predecessor at the helm of the central bank, Sahap Kavcioglu, who had slashed interest rates in line with Erdogan's wishes, became the new head of Turkey's banking regulator. Accordingly, Erik Meyersson, chief emerging markets strategist at Swedish bank SEB, warned that the new role of Kavcioglu, the previous head of the central bank, meant that Erdogan's unorthodox policy "could come back at any time."

This article was adapted from the original German.