Turkey, in the midst of a currency crisis which is quickly becoming a private sector debt crisis, appears headed toward stagflation — high inflation coupled with a contracting economy.
The country’s inflation as measured by the Consumer Price Index (CPI) rose 2.05 points in August to nearly 18% — the highest level seen since 2003 according to central bank figures released on Monday.
The Turkish lira’s depreciation is behind the rising trend in inflation.
The Turkish economy is heavily dependent on imported intermediary goods and even imported agricultural products, reflected by the fluctuations in food products.
The lira has lost 76% of its value against the dollar since January 2018, pushing up the cost of a wide variety of goods.
After the release of the inflation data on Monday, Turkey’s central bank signalled that it might take “necessary actions” against “significant risks to price stability”.
The central bank’s short statement read: “Monetary stance will be adjusted at the September Monetary Policy Committee Meeting in view of the latest developments. The Central Bank will continue to use all available instruments in pursuit of the price stability objective.”
Observers and markets assess this statement to mean the central bank will increase the interest rate at the upcoming September 13 meeting.
The real worry comes from the difference between the Producer Price Index (PPI) and CPI. Due to weak domestic demand, producers are unable to transfer rising costs to their consumers in full.
Hence, while PPI reached 32.3% in August, the disparity between PPI and CPI is as wide as 14 percentage points. This suggests annual inflation, or CPI, could hit 20% this month.
On top of that, the Turkish government finally raised natural gas prices and electricity prices by 14% and 9% respectively. The AKP government preferred not to pass the cost of the lira’s depreciation to voters until after snap elections in June.
The central bank left rates on hold at its last meeting in July, which weakened the lira further. The bank last raised rates in June and increased its one-week repo rate by 1.25 percentage points, to 17.75%.
The last implicit measure of the bank to support the Turkish lira was to decrease the tax rate on lira deposits to 5% from 15% and increase the tax rate on deposits in foreign currency to 20% from 18%, effective for three months. This measure will increase the budget deficit and worsen income inequality.
With inflation at 17.9% and the higher band of the bank’s policy rate at 19.75%, the bank is expected to raise the interest rate by at least 2 percentage points to support the lira and keep its promise of price stability.
Aversion to interest
It is well known in Turkey that President Recep Tayyip Erdoğan does not like raising interest rates.
He believes that higher interest rates are the reason for high inflation. He even prompted one of the highest losses to the lira before the elections in May, when he laid out his unique interest rate theory to foreign financial investors in London.
The central bank’s hesitation is in part due to Erdoğan’s pressure.
The Turkish leader believes his nation is fighting an “economic war” started by foreign enemies. He recently repeated that the hegemony of the dollar in international trade should be put to an end.
Erdoğan has said several times that Turkey should try to conduct trade agreements with its partners using local currencies, rather than the dollar. Pro-government media reported that Turkey tried to come to a trade agreement with Russia to use local currencies for their trade.
However, experts and observers warn that using local currencies instead of a reserve currency such as the dollar or euro is only possible if the countries have mutually balanced trade accounts.
All this seemingly unreasonable rhetoric from Erdoğan indicates the deadlock the economy has been driven into.
The most important reason Erdoğan and the managers of the Turkish economy have not raised the interest rate comes from the country’s heavy dependence on debt.
The Turkish economy has for years enjoyed debt-driven growth thanks to lower costs. Private companies that produce for domestic markets even started in 2009 to borrow in foreign currencies, either from domestic banks or from foreign markets. That trend of debt-driven growth hit a wall in 2016.
Raising interest rates will also complicate the real sector’s situation.
Hüseyin Aydın, the Chairman of the Banks Association of Turkey, revealed that by the end of 2017, restructured corporation loans will top 78 billion Turkish lira, according to the BBC.
Other reports suggest numerous companies have been sitting down with the banks to restructure their debt payments.
Higher interest rates are particularly painful for the construction and real estate sector and for small and medium-sized firms.
To support those firms, the Turkish government is trying to make a deal with the banks for reasonable borrowing conditions and restructuring. The government also announced that a Credit Guarantee Fund, in existence since 2016, will be made available again for companies to have “breathing credit”.
The real estate sector is openly demanding debt relief measures from the government.
Necdet Takva, the chairman of the Union of Chambers and Commodity Exchanges, said that “the debt of firms is the debt of 81 million Turkish citizens”.
“Collapse must be prevented,” he said, implying a willingness to pass on the burden of the crisis to the tax payers.
Hence, the economy is in a major dilemma: on the one hand raising interest rates may cause companies to go bankrupt; on the other, depreciation of the Turkish lira would increase inflation and the cost of financing foreign exchange, and further increase the need to raise interest rates.
According to the central bank’s Financial Stability Report, the size of non-financial firms’ foreign exchange open position was $223 billion as of May.
At the start of 2018, Ankara prohibited companies whose income was not in foreign currency to use FX loans, a decision that went into effect in May. Experts rightly said that the decision should have been taken as early as 2013, when the US and European central banks declared they would start monetary tightening.
To stop the endless slide of the Turkish lira, the AKP government has tried to encourage foreign investments to return to Turkey. However, foreign capital flows turned negative in March, while net foreign portfolio investments started to decrease the same month.
From March to June, net portfolio investments — totaling $15.7 billion in 2017 — dropped to negative $5 billion.
Political fixes for economic problems?
In the midst of its political and economic turmoil and diplomatic standoff with the United States, Ankara has tried to pivot once again to the European Union, its biggest trading partner.
Erdoğan pragmatically repeats that Turkey will not give up on its goal of joining the EU, but he has also repeatedly blamed European countries for supporting terrorists and using double standards against Turkey. In October of last year, he said Turkey does not need the EU after a diplomatic crisis with the Netherlands.
Moreover, The European Commission’s accession progress report in April stated that “Turkey has made big steps away from the EU”.
The report concluded that “under the current circumstances, it is unthinkable to open up new [accession] chapters”, as Turkey had taken significant steps backward in the areas of justice, public administrative reform, fundamental rights and freedom of expression. It also highlighted a two-year long state of emergency.
Though Turkey lifted the state of emergency in July following elections, it was replaced with regulations granting the government similar privileges the state of emergency provides, effective for three years.
Although Turkey’s ongoing political crisis with the US has forced warmer relations with the EU, this diplomatic offensive will not be as easy as pro-government media suggest.
One week ago, French President Emmanuel Macron disappointingly said: “Today’s Turkey is no longer Mustafa Kemal Atatürk’s Turkey … Turkey is confirming its pan-Islamic agenda every day, which seems against Europe.”
The French leader openly suggested that Turkey and Russia can only be seen as Europe’s “strategic partners” and Turkey cannot be a member of the EU.
Erdoğan in recent weeks held phone calls with German Chancellor Angela Merkel, who has been friendlier than Macron, and UK Prime Minister Theresa May.
Turkish Treasury and Finance Minister Berat Albayrak, Erdoğan’s son-in-law, has meanwhile met with his German and French counterparts and is paying another visit to British investors in London this week.
But even if these initiatives are successful, the solution will be temporary as all indicators show the economy is running toward stagflation, promising hard months ahead.
The economic confidence index dropped to 83.9 in August after a 9% decrease compared to the previous month. When economic agents have optimistic expectations about the economy, that figure is more than 100.
The decrease in the economic confidence index stems from the decreases in consumer, real estate sector, services, retail trade and construction confidence indices, which dropped to 68.3, 96.3, 88, 93.4 and 68.8 in August, respectively.
The only seemingly positive news on the economic front came from trade data. Turkey’s foreign trade deficit in August fell 58% year-on-year.
That was due, in part, to a sharp decline in imports (22.4% to $14.8 billion) and a limited increase in exports.
However, economists warn that a two-month decline in imports also suggests the Turkish economy is shrinking, as production is heavily dependent on imported goods.
Recently, S&P Global Ratings lowered Turkey’s long-term foreign currency sovereign credit rating to ‘B+’ from ‘BB-‘ with a stable outlook.
Moody’s Investors Service also downgraded Turkey’s sovereign rating to ‘Ba3’ from ‘Ba2’ and revised the outlook to negative.
The downgrade decision of S&P was based on “the extreme volatility of the Turkish lira and the resulting projected sharp balance of payments adjustment”. S&P Global also projected the Turkish economy to sink into a recession in 2019 and inflation to accelerate to 22% in the coming four months.
As this piece was being written, the government announced a new regulation to prevent fresh losses to the lira, according to Turkish news outlet Bianet.
The Ministry of Treasury and Finance, in a bid to protect the value of the lira, announced that income derived from exports should be received within 180 days (360 days for constructing firms). At least 80% of those incomes must be sold to a bank.
The banks that mediates exports will be responsible for monitoring those transactions. Effective immediately, the regulation will remain for six months.
Turkey’s economic problems are deeply rooted. The lira’s slide and the lack of confidence in the government comes from the government’s own policies, which do not offer a serious solution or plan.
However, given the hardening conditions for emerging markets, it is fair to accept there is no easy solution for the country’s economic woes.
Every step by Erdoğan and his government suggests that they are very far from grasping the seriousness of the situation.