Turkish President Recep Erdogan’s pride in his country’s recent interest rate cut is reminiscent of the apocryphal story of mother’s pride in her son during a military parade. The source of his pride was that his son was the only one in the parade who, in his mind at least, was marching in step.
Erdogan is also proud of his country’s central bank interest rate cut at a time of rising domestic inflation. It does so even when most of the world’s central banks, including those in emerging markets, are tightening monetary policies in response to signs of rising inflation.
In the past year, Erdogan has fired three central bank governors for not conforming to his eccentric view that high interest rates are the cause of inflation, rather than a cure. Last week, Sahap Kavcioglu, Turkey’s most recent central bank governor, appeared to give in to Erdogan’s demands by cutting interest rates by 100 basis points from 18% to 17%. He did so even at a time when inflation had accelerated to 19%. It also did so at a time when the Turkish lira was the worst performing currency in the world, as highlighted by the currency’s 16% decline since the start of the year.
Even more surprising about Turkey’s sharp interest rate cut was that it ran counter to the International Monetary Fund’s (IMF) explicit warning about the dangers of such a move.
In a recent report, the IMF observed that even before COVID-19, the Turkish economy suffered from external vulnerabilities in the form of uncomfortably low international reserves, a large amount of dollar deposits from the banking system, and an amount high corporate debt denominated in dollars. These vulnerabilities have increased due to the very strong monetary policy response to the COVID-19 crisis. This was underscored by the re-emergence of a large external current account deficit and an increase in dollar-denominated deposits to 60% of all deposits in the banking system.
Despite the country’s fragile banking system, low level of international reserves, and uncomfortably high amount of dollar-denominated corporate debt, it managed to avert a full-blown currency crisis. It did so because its banks continued to have easy access to a global capital market flooded with liquidity and which made international investors desperate for yields in an environment of low global interest rates.
Making Erdogan’s bet all the more reckless is the high probability that we are heading towards a less favorable international liquidity environment. In response to the first signs of inflation in many countries, many central banks have already started to tighten their policies. Meanwhile, Federal Reserve Chairman Jerome Powell is giving more and more signs that the Federal Reserve is about to start scaling back its aggressive bond-buying program, which he says should take end by mid-2022. This risks putting Turkey back in the forefront of emerging market economies which will be severely affected by a shift towards tighter global monetary policy conditions, as happened during the 2013 Bernanke Taper Tantrum.
None of this bodes well for the Turkish economy as its presidential elections approach in 2023. Domestic and foreign investors will likely head for the door as they see interest rates lagging behind. inflation and interest rates abroad are becoming more attractive. This in turn should send the currency to even lower levels, which will fuel the rise in domestic inflation for which Erdogan could pay a heavy price in the 2023 election.
On the bright side, Turkey’s economic woes may serve as a warning to other emerging market economies of the dangers of pursuing unorthodox monetary policies in an era of tightening global liquidity conditions. It could also serve as an early warning to policymakers in advanced industrial countries of potential future problems in emerging market economies.
Desmond Lachman is a senior researcher at the American Enterprise Institute. He was previously Deputy Director of the Policy Development and Review Department of the International Monetary Fund and Chief Emerging Market Economics Strategist at Salomon Smith Barney.