Turkish lira stabilises with rate hikes, but tensions for economy persist

Turkey’s lira has stabilised after the central bank increased its benchmark interest rate to a lofty 17 percent, but tensions in the maligned economy persist due to inherent imbalances that cannot be cured just by tightening monetary policy.

The week in Turkey began with important new data releases, paramount among them being the balance of payments figures for November. The current account posted a deficit of $4.1 billion, the central bank said, increasing the 12-month rolling deficit to $38 billion.

The current account registered a $10 billion surplus last year. But with government efforts to stimulate the economy during the outbreak of COVID-19, there has been a huge negative shift. Turkey now needs an equal amount of foreign capital to finance the shortfall in its national accounts, which is equivalent to 5 percent of economic output.

The current account has returned to a deficit after the country’s tourism revenues were hit hard by the pandemic and the government turned to domestic consumption to railroad economic growth.

Former Treasury and Finance Minister Berat Albayrak, the son-in-law of President Recep Tayyip Erdoğan, had hailed the current account surplus of 2019 as a success story for the Turkish economy. At the same time, he insisted that economic growth was recovering, and that Turkey was well on the way to solving its historical current account deficit problem. But when government stimulus provoked more domestic consumption during 2020, and hence demand for imports, the premise that Turkey could somehow maintain a positive balance of payments was proven false.

Bigger budget deficits and higher public debt can be regarded as the new normal for developed and developing economies because of the economic contractions caused by COVID-19. Many governments have increased state support for their economies enormously to ensure financial losses caused by the health crisis do not become permanent and that jobs are protected.

In an environment of abundant global liquidity, the resolution of imbalances in many economies around the world can be postponed to a future date despite a huge spike in public debt levels. Why? Because inflation – for now – is almost non-existent.

But in Turkey, the economic policy mistakes of the government, which included flooding the economy with cheap loans and pressuring the central bank to keep interest rates at below the rate of inflation, elevated annual price increases in Turkey last year to around 20 percent. The decision to stimulate growth with the low-cost loans also increased the indebtedness of Turkish citizens.

Turkey was among the few countries to post economic growth in 2020 as a whole – the economy expanded by an annual 4.5 percent in the first quarter, contracted by 9.9 percent in the three months to June, and then grew again at a rate of 6.7 percent in the third quarter. Growth in the final three months of 2020 will probably be about 5 percent.

But the negative side effects of this brand of growth have been high inflation, a big current account deficit and an increasingly worthless Turkish lira, along with a seriously large budget deficit.

In 2021, while the economies of many developed and emerging market economies are set to grow above their potential, the macroeconomic imbalances created during 2020 in Turkey will keep its growth path below historical norms.

With a current account deficit of 5.1 percent of GDP, weaknesses in financing capabilities and a shortfall of about $50 billion in the central bank’s net foreign currency reserves, Turkey's economic position is starkly different from that of its peers.

Developing countries generally posted current account surpluses in 2020. With inflation averaging around 4 percent, their currencies generally did not come under any great strain. These economies succeeded in attracting foreign capital, partly due to dollar weakness, especially during the last quarter of 2020. This, of course, resulted in significant increases in their foreign exchange reserves.

The government’s grave economic policy mistakes resulted in Albayrak’s resignation and the sacking of the central bank’s governor in early November. The bank then set about hiking interest rates substantially. Since then, we have not heard Erdoğan voice his regular refrain that high interest rates are the cause of inflation. In fact, considering the increase in interest rates by around 1,000 basis points, or 10 percentage points, since the summer, one can even conclude that the president has abandoned his controversial theory.

Yet, the balance of payments figures in Turkey do not lie.  

Rate hikes are finally serving their purpose. Losses for the Turkish lira have reversed, the current account deficit has probably peaked during November and December, and the meltdown in Turkey’s foreign exchange reserves has abated. 

The November balance of payments figures show that the central bank’s higher interest rates attracted foreign capital to the country. However, such capital inflows are not a cure-all. This money, which entered the stock and bond markets, is invested in easily cashable assets, and has arrived after the dollar weakened internationally and the lira strengthened. By nature, these capital inflows can swiftly become outflows.  

Such a short-term drive for profit by foreigners in Turkey is neither forbidden nor malicious, but rather a reality of global markets. Mandatory real interest rate increases in countries where things go wrong, or the economy overheats, end up offering easy profits for investors. Such a situation is now unfolding in Turkey with the value of the lira becoming the barometer.

The president’s pledges of economic and judicial reforms, which have accompanied the rate hikes, have also helped the lira. Yet, it now appears that those reforms will be limited to regulations to encourage and protect foreign capital entering Turkey.

The government is unable to enact real reforms and that problem is reflected in its dwindling popularity. Recent opinion polls show that the governing Justice and Development Party (AKP) and its far-right ally, the Nationalist Movement Party (MHP), are losing ground against their political rivals. The only way now for the AKP to preserve its majority in parliament and public support for Erdoğan is through preserving its partnership with the MHP. The only means to maintain that partnership is to keep escalating political tensions in the country and fuel polarisation.

Given Turkey’s unique political dynamics, the recent interest rate hikes are likely to secure some $1-1.5 billion per month in foreign portfolio inflows, mirroring the investments seen in November balance of payments data.  This means that at least during the first months of 2021, the lira is likely to preserve its gains and perhaps rally a little further.

However, political tensions in the country remain intense. MHP leader Devlet Bahçeli has declared that he will file court proceedings for the closure of Turkey’s main pro-Kurdish political party. He has suggested that he may open a similar case against the main opposition Republican People’s Party (CHP)-İYİ Party alliance. Meanwhile, Erdoğan has basically announced that almost anyone in Turkey who thinks differently or opposes his governing AKP-MHP coalition can be considered a terrorist. These statements have added to high political tensions in the country.

It seems that the AKP-MHP coalition will use polarisation of the electorate as a main policy tool until presidential and parliamentary elections, due in 2023.  Such a strategy, coupled with the lack of real economic reform, will soon render Turkey’s new high interest rate monetary policy ineffective in keeping the Turkish economy stable.       

One of the clearest signals of this impending failure comes from the owners of domestic capital.  Locals have not joined foreign investors in piling into the lira. In fact, quite the opposite. They bought another $2 billion of foreign currency in the last week of 2020, increasing their foreign exchange deposits to a new record high.