Erdogan's new team demeanor made it clear that Turkey would return to traditional economic policies, with Erdogan's implicit approval.
Ali Noureddine
This article was translated from Arabic to English
Turkish President Recep Tayyip Erdogan has consistently displayed inflexibility and a commitment to unorthodox economic policies, notably his unwavering emphasis on reducing interest rates and curbing the independence of the Central Bank.
On various occasions, Erdogan’s speeches have suggested that his economic strategies are influenced by his Islamic background, particularly when he highlights that “interest is the root of all evil,” reflecting the opposition among many Islamists to the principle of interest, deemed as usury, which is prohibited by Sharia law.
Conflicting theories
During his years in power, Erdogan often reiterated arguments that justified his unconventional policies. One such argument was his repeated claim that high interest rates fuel inflation and contribute to rising prices, a viewpoint that radically contradicts accepted globally economic theories.
Based on this unfamiliar theory, Erdogan kept repeating his promises to the Turkish people that he would curb inflation, improve purchasing power and lower the cost of living by reducing interest rates. However, as is well known today, Erdogan has repeatedly failed to substantiate the validity of his theories, just as he has failed to rein in inflation.
Contrary to Erdogan’s assertions and gambles, central banks typically raise interest rates to curb inflation when prices rise in the market. Raising interest rates automatically translate to higher debt costs, which in turn reduce borrowing and limit the flow of liquidity into the market.
Moreover, higher interest rates make bank deposits more appealing and profitable, thereby encouraging families and investors to deposit their funds in banks. Consequently, raising interest rates leads to a decrease in the overall money supply, a reduction in spending rates, and ultimately a decline in prices and inflation rates.
Meanwhile, in contrast to Erdogan’s approach, central banks in developing countries are actually inclined to raise interest rates as a strategy to attract foreign currency liquidity and prevent the depreciation of their local currencies. This approach effectively brings down inflation rates stemming from the low exchange rate of the domestic currency.
Such policies are typically implemented during periods of high interest rates in developed countries, as is the current scenario, to prevent the outflow of foreign currency liquidity from developing markets to the developed ones.
However, as Erdogan’s theories directly contradict the conventional logic followed by central banks, this pushed him to dismiss three consecutive Central Bank governors between 2019 and 2021 since they deviated from his theories.
In addition, he removed several Central Bank officials and even altered the bank’s structure by eliminating certain positions. Consequently, Erdogan went down an unconventional path, seeking to completely undermine the independence of the Central Bank and subject it to his own desires and whims.
Thus, he enforced his vision and theories upon the Central Bank and the monetary policy of Turkiye, capitalizing on constitutional amendments implemented in 2017, which transitioned the country to a presidential system and bestowed extensive powers upon Erdogan.
From 2021 to 2023, Erdogan persisted in pressuring the Central Bank to pursue an interest rate reduction policy, despite the rapid rise in inflation rates and the deterioration of the Turkish lira’s exchange rate. Throughout this period, he remained steadfast in his economic theories, even in opposition to market expectations.
Repercussions of Erdogan’s unconventional policies
It doesn’t take much to see the consequences of Erdogan’s unorthodox policies. By the end of the first quarter of 2023, the annual inflation rate soared to 50.51 per cent as a result of interest rate cuts. In fact, by August 2022, inflation had already reached an alarming level of around 80.2 per cent, marking the highest point in over 24 years.
In essence, Turkiye’s interest rate reduction policies have led to record-breaking inflation rates, aligning with traditional economic theories, while disproving Erdogan’s unfamiliar notions that suggest prices would decrease.
Conversely, as Erdogan pursued interest rate cuts in Turkiye, the U.S. Federal Reserve and the European Central Bank were raising interest rates to tackle inflation in the United States and Europe. Consequently, capital began to flow out of Turkiye in foreign currencies, heading toward Western markets, which contributed to the devaluation of the Turkish lira against foreign currencies.
As a result, the exchange rate between the U.S. dollar and the Turkish lira surged from 7.43 liras at the beginning of 2021 to 19.18 liras by the end of the first quarter of 2023, marking a staggering increase of approximately 2.6 times the value of the U.S. dollar in the Turkish currency market. This depreciation of the local currency automatically escalates the cost of imports, further exacerbating inflation rates.
The overall turbulence on the economic front has eroded investor confidence in Turkiye as the persistently high inflation rates and abrupt fluctuations in the local currency exchange rate now pose a significant threat to the actual value of any potential investments in the Turkish market. The hasty and ill-conceived economic policies, coupled with unwarranted interference in the Central Bank’s operations, have all contributed to undermining the credibility of the Turkish government and its financial plans.
Thus, before attempting to devise any new strategies for economic recovery, the Turkish government must first regain the trust of the markets.
Erdogan’s new staff: A surprising post-election turnaround
During his election campaign leading up to his re-election in May 2023, Erdogan reiterated his conviction in his economic ideas and theories, making it clear that he would not deviate from this approach after the vote. Even after securing victory, Erdogan’s speeches provided no indication of his intention to step back from his unconventional policies.
Consequently, the announcement of Erdogan’s win was met with concern among markets and investors, leading to further depreciation of the Turkish lira.
However, as soon as Erdogan formed his new team following the elections, it became evident from their demeanor that Turkiye was heading toward a return to more traditional economic policies, with Erdogan’s implicit approval. It became clear that Erdogan’s earlier speeches, emphasizing his previous approach, were merely campaign rhetoric intended to divert public opinion from holding him accountable for the high inflation and unemployment rates.
The initial sign of the country’s shift towards traditional economic policies was the appointment of Mehmet Simsek as the Minister of Treasury and Finance in Erdogan’s new government after the May 2023 elections.
Simsek, a strategist and former expert at Merrill Lynch Bank, had gained recognition since 2018 for consistently criticizing Erdogan’s unconventional policies and advocating for a return to familiar monetary management policies. His selection as minister of treasury and finance in Erdogan’s government was met with relief among Turkish investors.
Simsek is no stranger to Turkish politics, having served as the minister of finance from 2009 to 2018. During his tenure, he successfully maintained inflation rates at acceptable levels, in stark contrast to the current situation. At that time, Simsek relied on conventional policies, which included safeguarding the independence of the central bank and utilizing standard monetary policy tools, including raising interest rates, to combat inflation.
However, Simsek departed from the Turkish government in 2018, coinciding with Turkiye’s transition to a presidential system that granted Erdogan the power to impose his financial vision across all branches of the executive authority. Since then, Simsek has been warning about Erdogan’s approach, although his warnings did not garner much acceptance from the Turkish regime.
Known as a friend of investors in Turkish economic circles, Simsek promptly assured the Turkish people that he would now strive to steer Turkiye toward “traditional, realistic and rational policies.” He emphasized that Turkiye had no other option to restore financial and monetary order to the country. Simsek made his future goals clear, focusing on combating inflation through “structural reforms in the Central Bank,” highlighting the need to rectify the monetary policies that had been characterized by absurdity in recent years.
Before agreeing to return as minister of treasury and finance, Simsek received assurances from Erdogan regarding the preservation of the Central Bank’s independence and the provision of flexibility to the Ministry of Treasury and Finance to develop financial policies aimed at controlling inflation and restoring fiscal balance.
It was also stipulated that Erdogan would not interfere with necessary interest rate adjustments and that economic and monetary statements would be issued by the government as a whole, rather than solely by the head of state. Simsek’s return to the government thus signaled a shift back to the traditional approach in managing monetary policy, contrasting with Erdogan’s previous methods.
Another indication of Turkiye’s inclination towards traditional politics was the selection of Hafiza Ghaya Arkan as the new governor of the Central Bank, replacing Sahap Kavcıoglu. Arkan, an executive banker with previous experience at Goldman Sachs and the First Republic Bank in the U.S., is known for her adherence to traditional monetary policies.
Turkish economic analysts considered Arkan’s selection as another sign of the country’s shift towards normalizing monetary policy after years of uncalculated interest rate cuts. Consequently, the era of the former governor, Sahap Kavcıoglu, who enabled Erdogan to exert control over the Central Bank’s decisions and impose unconventional monetary policies since 2021, came to an end.
It is worth noting that Erdogan replaced 15 out of 17 ministers in his new government, demonstrating his desire to introduce fresh perspectives into the executive authority. In selecting the new ministers, Erdogan prioritized technocratic individuals who possessed expertise in their respective ministries, showcasing a pragmatic approach focused on enhancing the performance of the government team.
Political factors push Erdogan towards realism
The rationale and pragmatism behind Erdogan’s shift toward traditional economic policies can be attributed to several political factors at play.
One prominent factor is the declining popularity of the Justice and Development Party in major cities such as Ankara and Istanbul, as evident in the recent election results compared to previous sessions. Voters in these cities tend to place significant importance on economic performance when making electoral decisions, particularly in relation to inflation, unemployment, growth, and public services.
Another factor is the increased bargaining power of Erdogan’s main ally in the ruling coalition, the Nationalist Movement Party. As the popularity of the Justice and Development Party led by Erdogan wanes, the Nationalist Movement Party has advocated for adjustments in the government’s economic policies to mitigate the declining support for the ruling coalition. Notably, the Nationalist Movement Party faces fierce competition from other nationalist and right-wing parties that have united under the umbrella of the Turkish opposition.
Moving forward, the Turkish Central Bank is set to benefit from bilateral agreements, which enabled attracting a $5 billion deposit from the Kingdom of Saudi Arabia. Additionally, the expansion of energy projects and gas extraction in the Black Sea will contribute to increased foreign currency liquidity flows into Turkiye.
These factors will aid Erdogan in normalizing Turkish monetary policy while maintaining a minimum level of economic stability, albeit at the expense of moving away from his previous approach.
If the Justice and Development Party continues to remain in power beyond Erdogan’s current term, it will necessitate a return to sustainable and stable financial policies instead of the unrealistic policies that have been proven ineffective by the markets.