The power of monetary policy lies in our governments and central bank’s ability to influence the supply of money, credit, and the economic well-being of its citizens. However, even though monetary policy can be a powerful tool, it must also be wielded with caution as its repercussions can be far-reaching. Thus, as wars and pandemics have sent the world into an uncontrollable inflationary spiral this year, it is worth noting countries who have taken drastic measures to ensure stability in their respective economies. In this paper, Turkey’s current monetary prescriptions will be carefully analyzed due to its radical expansionary policies amidst skyrocketing inflation and currency devaluation. It will subsequently provide background information on Turkey’s economic history and current state of affairs. Lastly, this paper will curate economic models and introduce critical perspectives before delving into the author’s personal critique of Turkey’s economy.  

Turkish Economy History

The demise of the Ottoman Empire in 1922 led to the birth of the Republic of Turkey, leaving this newly minted nation with unsustainable war debts from the First Balkan War and World War I. From the onset, Turkey was underdeveloped – largely driven by subsistence agriculture and sparse food and textile factories (Sachs). Recognizing the need for an immediate revitalization, the Turkish government formulated a new ideology – statism, which sought a “middle way between Soviet-style comprehensive planning and a Western-style market economy system” (Sachs). Gradually, this ideology paved the way for the ruling of the AKP Democratic Party in 1950, as the Turkish government and investors tapped the international capital markets.

By the 1980s, despite an export-led expansion, the country’s deepest crisis was brewing. A combination of over-reliance on short-term borrowing, large budget deficits, and the Persian War finally led the dominos to fall in 2000 (Özatay). In November of that year, banks started to close their interbank credit lines and sold off securities to meet margin calls. This banking crisis soon led to an exchange rate crisis as foreign exchange reserves were depleted, initialing a speculative attack against the lira, which eventually free-floated and lost a third of its value  (Rabobank). Thereafter, Turkey experienced an economic boom during the turn of the century, and it was surprisingly well-insulated from the GFC, only seeing GDP growth decrease by 0.6% (Rawdanowicz). Today, Turkey remains an “emerging market economy” driven by its agricultural, textile and construction sector. Led by the draconian President Recep Erdogan, he has vowed to improve the standard of living of its 85 million citizens; however, his track record has little to show for except for his peculiar stance on monetary policy.

This is the crucial backstory for which the narrative of Turkey’s present day economic analysis will continue.

Current State of Affairs

The value of the Turkish lira (TRY) has been in steady devaluation in the past decade. As of 2010, 1 USD could be traded for 1.5 TRY, but that number has risen to 18.6 TRY as of December 19^th, 2022. Moreover, it is currently not explicitly pegged to any select currency, but throughout its history, the TRY has been pegged to the British pound, the French franc, and the U.S. dollar (Investopedia). Moreover, the nominal value of the lira is largely decided by the Central Bank of Turkey (CBRT), who with $67B in foreign reserves, leave themselves the option of intervening and influencing currency markets whenever necessary (Trading Economics).

In 2020, Turkey’s management of COVID-19 was swift but focused on credit expansion. This proved effective to help the economy back on its feet but also stoked the fire for inflation. Compounded with high energy prices due to the Russian-Ukraine conflict, price levels have only exacerbated in Turkey – reaching a historic 83%, the highest level in 23 years. In the same vein, the “natural unemployment level is 10% and this exceeds 20% when discouraged workers are included” (Kubilay).

Despite rocketing inflation and a deepening employment crisis, the CBRT, under pressure from President Erdogan, has demanded interest rates fall towards single digits this year. In the months of August, September, and November, the CBRT cut rates by a total of 350 bps (AP News). This represents a 14% interest rate shift to 9% in a matter of five months. The CBRT rationale is clearly outlined in its press statement, citing: “The Committee expects the disinflation process to start on the back of measures taken. Additionally, leading indicators for the third quarter point to some loss of momentum in economic activity, thus it is important that financial conditions remain supportive to preserve the growth momentum and stability in the general price level” (TCMB). In other words, Erdogan’s staunch mindset believes high borrowing costs cause inflation, and low rates during times of inflation would boost business activity and stable price levels. Such policies prescriptions run counterintuitive to traditional monetary policy packages we are accustomed to learning, which is what makes them a fascinating case study within international finance.

Like the early 1900s, Turkey remains an indebted nation with $2.9B of current account deficits (Trading Economics). This means Turkey imports more than it exports. Moreover, because the current account reflects the balance between savings and investment, it is also safe to say that Turkey has low national savings compared to a high rate of investment (Feenstra).

In addition, Turkey is also indebted to foreign countries and investors – to the tune of $451B (Kubilay). Unsurprisingly, Turkey’s growth has been fueled by excessive leverage from its external debt. Of which, half of the debt is underwritten in foreign currencies including the USD, JPY, and EUR (Commodity). This reflects the concept of original sin – the inability for Turkey to borrow in its own currency due to lack of creditor trustworthiness. In fact, the total debt burden has ballooned from “77% of GDP in 2000 to 129% in 2020” (CFA). These shocking figures makes Turkey susceptible to liability dollarization – where a depreciation in the lira decreases national wealth by increasing the value of a net foreign currency debit position (Feenstra). This has caused Moody’s to downgrade Turkey’s long-term FX denominated sovereign debt to B3, the lowest rating in the last 30 years (Moody’s). Moreover, the amalgamation of these concerning trends have caught the eye of foreign investors, who have altogether pulled $7.6B of capital away from the country (Bloomberg).

To make matters worse, the country is experiencing a slew of social and political unrest as a result. The poverty rate in 2020 was 10.2% and many educated youths are choosing to emigrate to other countries, initiating a process of the brain drain (MacroTrends). In the minds of the new college graduates, Turkey is no longer a nation where they can have access to opportunity and stable financial outcomes. This is also evident politically, where thousands of people have rallied against the indictment of  presidential candidate Ekrem Imamoglu and former head of the CBRT Naci Agbal, further causing disruptions across the social fabric of the country as President Erdogan’s strengthens his stranglehold on the nation’s future.

Critical Perspectives

Academics and central bankers have long berated Turkey’s illogical economic policy. For example, Refet Gürkaynak of Turkey’s Bilkent University cites it as a “cautionary tale of the dismal effects of ignoring basic macroeconomics while providing an unfortunately clean exogenous variance in the policy rule” (Gürkaynak). He has urged for lowering inflation expectations as a result. Hakan Aran, CEO of Isbank and Turkey’s largest lender, has openly criticized Erdogan’s policies as “putting at risk both the banking system and the success of Turkey’s so-called new economy model” (Bloomberg). Furthermore, Sinan Ülgen at Carnegie Europe cites Erdogan’s policies “eliminate any improvement in international competitiveness in the medium term. More importantly, the prevailing negative real interest rate will continuously trigger a flight of savings from the Turkish lira to foreign currencies, leaving no incentives to save” (Ulgen). On the other hand, some critics see the validity of his policies to an extent. Lower interest rates will increase employment and investment and the lira’s devaluation will decrease imports and narrow the current account deficit.

Personal Critique

The unfortunate truth about economics is that it is inextricably linked to politics. With approval ratings for his AKP Party receding, President Erdogan desperately recognizes his re-election campaign next June is dictated by a strong economy. However, with a deeply religious background, he calls high interest rates “mother and father of all evil” and vowed to “never compromise on the issue” (Karaganis). Despite this, his radical policies have yet to send Turkey into a full blown “devaluation-hyperinflation” scenario as seen in Argentina or Venezuela, and for a moment, there seems to be a moment of reprieve. Therefore, in addition to avert an impending crisis, below are 6 immediate actions Turkey should take:

1. Implement contractionary fiscal policy: Turkey should take steps to address the volatility of its budget spending by utilizing contractionary measures such as cutting public spending and raising taxes. This is because deficits have been known to cause distortion of interest rates and rapid fluctuations in external wealth.

2. Increase interest rates: Fiscal and monetary measures must be in sync during times of crisis such as these. Thus, Erdogan must reconsider his radical economic experiment, and take a long-term perspective of the potential damages of lowering rates now. As the next central bank meeting occurs on December 22^nd, I urge Erdogan to use forward guidance and raise interest rates by at least 150 bps. Higher rates lower the demand for goods, thus keeping prices low. In addition, people will be encouraged to save more.

3. Election: Turkey desperately needs a swift overhaul of its president and cabinet. Erdogan’s AKP party approval ratings have sunk to historic lows, providing opposition Republican People’s Party (CHP) and the Nationalist Movement Party (MHP) a chance to challenge the incumbency next June (Ünlühisarcikli). However, if Erdogan wins, his new term limits would grant him presidency until 2034.

4. Increase foreign investment: The government must make it a top priority to encourage foreign investment by offering incentives, such as tax breaks and promises of fair competition. This will improve the overall business environment by reducing bureaucracy, making it easier for businesses to register and operate. This will not only restore investor confidence (lower risk premiums) but also boost technology, productivity, and job growth.

5. Promote exports: The government should promote exports by offering incentives to exporters by encouraging participation in trade associations and developing tailored export strategies. These measures will increase the trade balance, thereby reducing the current account deficit. Thus, the surplus can be used to increase reserves and other purposes.  

6. Increase foreign exchange reserves: There are two ways Turkey can increase its foreign exchange reserves, either by buying foreign currency or borrowing from international institutions.  These measures can increase the backing ratio (which currently stands at 12%) and better insulate the economy against running out of reserves.

The central bank’s track record can only be described as mixed at best. It has made efforts to restore bank confidence with $30B of deposit guarantees, stimulate growth via low borrowing costs, and actively narrow the current account deficit; however, inconsistent fiscal and monetary policies paired with erratic presidential decrees makes curing Turkey’s hyperinflation and currency devaluation even more difficult (NASDAQ). At the end of the day, policy prescriptions and recommendations are easier said than done as politics and corruption often stand in the way of mutually beneficial schemes. However, through these six measures mentioned above, I truly believe Turkey can restore to its former glory as a stabilizer between continents, promotor of innovation, and epitomize the success monetary policy can have upon nations. 

Below is my final paper submission for my class on International Finance during the Fall 2022 school year.

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