On 18 August 2022, the Turkish Central Bank (CBTR) cut its benchmark interest rate from 14 percent to 13 percent. It was the first rate reduction since 2021, when the CBTR cut its policy rate four times. The decision came as a surprise to many analysts, who noted the fact that most central banks have recently raised interest rates to curb rising inflation amid disruptions in global supply chains caused by the pandemic and Russia’s attack on Ukraine.
The official justification given by the CBRT is to maintain GDP growth momentum by stimulating the domestic market and supporting export-oriented sectors. What did not feature in the official press release was a pledge to confront rampant inflation. Given current socio-economic conditions in Turkey and conflicts in the international arena, this is a risk-prone policy move that President Recep Tayyip Erdoğan and the CBRT are apparently willing to take for political reasons.
Immediate Consequences
The reaction of capital markets was immediate and accelerated a trend already vibrant during the past year. The Turkish lira (TL) declined vis-à-vis the US dollar, again surpassing the critical threshold of 18 lira to the USD, signalling a level near historic lows. In 2021 alone, the TL lost 44 percent of its value against the USD. Since the beginning of 2022, the domestic currency has further devalued against the greenback.
The decline in the TL relative to the USD increases the price of imported goods, particularly energy commodities. Underpinning this development is a blistering surge in electricity prices, propelled by the soaring cost of natural gas. This spiral creates knock-on effects in other sectors of the Turkish economy, including industrial production, and increases the foreign currency credit exposure of private households and corporations. Consumer Price Inflation (CPI) hit a 24-year high of officially 79.6 percent in July 2022, although independent economists claim that the real rate has reached three digits. Against this background, we see further risks that Turkish society is facing hyperinflation. In our view, for a country that hosts nearly four million Syrian refugees and faces a general election next year, the socio-economic situation is fragile and cause for concern.
Foreign investors with exposure to Turkey are pricing in a higher risk of sovereign default, as reflected in the valuation of credit default swaps. The cost of insuring against default on $10,000 of five-year Turkish dollar bonds has risen to $780. Given the track record of the CBRT, further interest rate cuts cannot be dismissed ahead of the presidential and parliamentary elections due in mid-2023. President Erdoğan has repeatedly claimed that high interest rates lead to high inflation and dismissed three central bank governors for challenging this narrative.
Turkey in Line with Russia and China?
The main agenda item on most central bankers’ minds is how to bring down double-digit CPI. By contrast, Turkey, Russia and, most recently, China are cutting benchmark interest rates. The central bank in Moscow needs to address the economic consequences of Russia’s invasion in Ukraine, while monetary policy-making in Beijing is confronting the financial consequences of the strict zero-Covid strategy and a massive real estate crisis.
Ankara’s goals are different. The construction sector and its related industries have grown rapidly over the past two decades, representing nearly one third of Turkey’s GDP and employing millions of people. Due to the sector’s tendency to allow for nepotistic ties, Erdoğan used public-private projects in the construction sector to reward his cronies and siphon money towards his political allies. In the 2021 list of the world’s top 250 international contractors, Turkey is ranked third, after China and the US. Erdoğan also seeks to keep afloat the Anatolian small and mid-size enterprises that represent one of his strongest support bases. However, financing economic growth with repeated rate cuts will only make Turkey’s inflation problems worse and further depreciate the domestic currency.
But this may be part of Erdoğan’s risky plan. First, he cannot politically survive a return to economic orthodoxy in an election year. Raising interest rates would result in sharp increases in poverty and unemployment while diminishing Erdoğan’s electoral prospects. It is true that high inflation rates severely hit low- and middle-income urban voters. Yet, the president may calculate that as long as employment levels are not declining and minimum wages are regularly increased, as happened twice in the past seven months, his government can retain the support of most low-income voters. Owing to his conservative cultural agenda and social assistance programmes, he can still appeal to many impoverished voters. It is unlikely, however, that such a gamble will pay off at the ballot box.
