Most economists are in agreement that when there is an increase in inflation the central bank increases the base interest rates in order to reduce spending and encouraging saving. This takes money out of the circular flow and should lead to less borrowing and therefore less pressure on prices.
The Turkish lira dropped by 17% this year with three cuts in interest rates since September. This comes as inflation has climbed to 73.5%. So why would you drop interest rates when you have rapidly increasing inflation? President Erdogan sacked the governor of the head of central bank Naci Agbal who had been hiking interest rates to dampen down inflation – he was the third governor to lose his job in the last two years. Erdogan believes that raising interest rates would raise inflation rather than reduce it and he proceeded to cut rates further which saw an even steeper decline in the lira. An argument for this policy could be that the cheaper exports can drive economic growth.
The collapse of the lira make exports competitive and imports more expensive and in September Turkey posted a current account surplus thanks in large to a recovery in tourist numbers. Turkey relies heavily on imports of raw materials and energy and with the exchange rate falling these have become a lot more expensive. Although Turkish exports should be cheaper, the heavy import component of finished exports makes those goods more expensive so this outweighs the benefits of having a cheaper lira – e.g. in assembling kitchen appliances the price of imports of the component parts make the overall price of the appliance more expensive. This just fuels more inflation. Supermarkets are limiting customers to one item as they know people will stockpile produce with the ever increasing inflation rate.
So with inflation now at 73.5% and and interest rates at 14% this makes real interest rates = – 59.5%. The central bank kept its benchmark interest rate at 14% at its May meeting, extending a pause that followed 5% of cuts last year. This has led to the local population to turn to other currencies – US$ Euro – in order to protect the value of their money. Below is a very good video clip from Deutsche Welle (German World Service) outlining the crisis that Turkey face and how a policy of cutting interest rates has backfired.
Inflation at 25%, Central Bank interest rates at 24%, Lira down 30% in value since the start of the year. What hope is there for the Turkish economy?
Wages and salaries haven’t kept pace with inflation and the reduction in demand has led to higher unemployment. There is pressure on the central bank to keep interest rates to avoid the lira collapsing. However this makes it expensive for businesses to borrow money and thereby reducing investment and ultimately growth.
No pain no gain – there is no alternative for Turkey other than undertaking painful and unpopular economic reforms. Remember what Reagan said in the 1980’s “If not now, when? If not us, who?” He was referring to the stagflation conditions in the US economy at the time and how spending your way out of a recession, which had been the previous administration’s policy, didn’t work.
In order to the economy back on track things will need to get worse but President Erdogan has the time on his hands as there is neither parliamentary nor presidential elections in the next five years. This longer period should allow him the time to make painful adjustments without the pressure of elections which usually mean more short-term policies for political gain. Beyond stabilising the lira, which helped to ease the dollar-debt burden weighing on the country’s banks and corporate sectors, the 24 per cent interest rate level the central bank imposed also brought about a long-overdue economic adjustment. A cut in interest rates discourage net inflows of investment from foreigners and the resulting depreciation would accelerate the concerns about financial stability and deteriorating business and consumer confidence. Below is a mind map as to why a rise in the exchange rate maybe useful in reducing inflation.
The Turkish Economy, like many emerging economies, is suffering from a declining currency – the Lira. This is partly due to the US Federal Reserve expecting to increase interest rates over the next few months – higher interest rates tend to increase the value of a country’s currency. With a falling lira the cost of Turkey’s imports has increased which has fed through into inflation – this is at the same time that the economy is contracting. The dilemma for the Central Bank of the Republic of Turkey (CBRT) is whether to increase rates and stabilize the currency or to lower rates to boost economic growth.
With an election in June this year the Turkish President Recep Tayyip Erdogan wants the CBRT to lower rates and thereby stimulating economic growth. This he feels would increase GDP from its current rate of 1.7% but more importantly assist him and his Justice and Development party to a fourth straight election victory. However the CBRT has been lowering interest rates in an environment when the inflation rate is above the 5% target as well as a falling lira (see chart from The Economist) – this month they have kept interest rates at 7.5%. Erdogan has criticised the central bank for their lack of aggression in cutting rates and accused the central bank governor and his team of “treason.” It seems that this outburst has in itself caused the lira to fall and the currency to hit an all time low against the US$ earlier this month. Erdogan believes that cutting interest rates will reduce inflationary pressure which goes against all the evidence from central banks globally and mainstream economics.
If Erdogan does get to serve a fourth term who would bet against him trying to claim back some of the central bank’s independence and have government play a more influential role in controlling interest rates.
There is no doubt that Turkey has grown considerably over the last decade – in 2011 the economy grew by 8.5%. However, like other countries, this growth does have its side effects when you delve deeper. The main concerns are as follows:
1. With this growth comes pressure on prices – inflation was 10.4% in March this year which is well above the target by the Central Bank 2. In order to create the demand in its economy Turkey has put a growing reliance on foreign capital and hot money which has not been generated in Turkey itself. 3. Furthermore the capital itself seems to be quite fickle and doesn’t lend itself to major industrial developments. 4. As with most growing economies the reliance on overseas goods becomes very pronounced. Turkey’s trade deficit in 2011 was 10% of GDP
As long as the global economy is bouyant there are significant funds (hot money) which find there way into emerging economies like Turkey. However, once the clouds appear on the horizon hot money tends to depart which forces the Turkish Lira down and domestic consumption to fall. Turkish interest rates (approx 6%) have attracted hot money but the real problem here is that there is a significant shortage of domestic saving. Furthermore businesses don’t want to grow in size as there are a myriad of regulations and therefore are less efficient than if they were larger and able to achieve economies of scale.
To be more stable over the next few years the Turkish economy needs to reduce its current account deficit (see graph below) and its reliance on capital inflows. Persistent deficits will mean serious problems when money flees the economy.