Erdoğan saved the lira temporarily: What is needed for lasting success?
The Turkish economy has been vulnerable to periodic exchange rate shocks for many decades but the magnitude of the sudden drop in the value of the lira in the past three months was unprecedented.
The dollar exchange rate to the lira increased by 19 percent from 7.49 lira in January 2021 to 8.89 lira on Sept. 20. Then the depreciation of the lira accelerated and the dollar rose by a further 104 percent to 18.17 lira per dollar by Dec. 20.
This large devaluation was largely a result of the government’s refusal to support the lira by raising domestic interest rates. As the rising inflation rate was putting more pressure on the lira in 2021, President Recep Tayyip Erdoğan insisted on his long-held belief that interest rates had no connection with inflation and exchange rates and they (interest rates) must be gradually lowered to stimulate investment and economic growth. Acting on this belief, he ordered the central bank to lower the interest rate in several steps from 19 percent in September to 14 percent in December. It was this last rate reduction on Dec. 16 which triggered an exchange rate panic and finally forced the government to react.
This latest exchange rate crisis has had a severe impact on households buying power as the prices of many essential items have increased at a faster pace than average wages and incomes. A visible sign of the difficult economic conditions were the recent long lines in front of government-owned bakeries that sold bread at a subsidised price. Cases of property theft motivated by poverty have also increased.
This recent exchange rate crisis has also evolved into a political and social crisis. For the past two months, there have been several mass protests against rising inflation and poverty. Opposition political parties have become very vocal in their criticism of these policies. The Nationalist Movement Party (MHP) leader Devlet Bahçeli, a partner of the government, has stood by Erdoğan and accused opposition political parties of plotting to harm the economy through their harsh criticism of the government's low interest rate policy. At the same time, both Bahçeli and Erdoğan have condemned the country’s largest business association, TÜSİAD, for opposing the low interest rate policy.
Government’s Lira Rescue Plan:
In response to this escalating crisis, Erdoğan announced a new banking policy on Monday, Dec. 20 that caused a reversal in the dollar’s gains. He announced that the Turkish government will compensate lira-denominated time deposits (with lengths of 90 days, six months and twelve months) in the banking system against the depreciation of the lira. This lira rescue policy put an end to the depreciation of the lira but led to wild swings in the exchange rate on Dec. 21. The immediate result was a success and this initiative reduced the price of dollar from 18 lira to 11.5 lira by Dec. 23 and to under 11 lira by Dec. 25.
The “lira rescue” policy amounts to a large financial commitment by the Turkish government, which will be materialised if the lira depreciates in the coming months. In theory, this commitment is unlimited. If the public invests large quantities in these safe time deposits and the lira depreciates by a significant amount, these compensations can become a major fiscal burden on the treasury. Depending on how it will be financed, it might lead to higher budget deficits and more inflationary pressure.
This policy followed another economic policy announcement a few days earlier (Dec. 16), which raised the minimum wage by 50 percent. This wage adjustment was popular in face of the severe decline in purchasing power of wage-earners, but it will also increase the cost of production for the private sector which can lead to higher price levels in the coming months. The deputy chairman of the Justice and Development Party (AKP) (Erdoğan’s party) has announced that the salaries of government civil servants and retired pensioners will also be increased soon. This will increase government spending and if it causes an increase in the budget deficit, it can also put more pressure on prices and the exchange rate.
Looking beyond the immediate success:
This latest exchange rate crisis was to a large extent a direct result of Erdoğan’s ideological opposition to high interest rates and his ability to impose his monetary policies on the central bank. As the lira was depreciating. he should have allowed the central bank to make the lira more attractive by raising interest rates, which is the standard recipe in economic science and Turkey has applied it several times in the past. Instead, he moved the interest rates in the opposite direction and worsened the crisis. Yet at the same time, his swift reaction to the crisis on Dec. 20 has contained the crisis in the short run.
Hence, while Erdoğan and his economic team are responsible for the crisis, they also deserve credit for finally recognising the danger and announcing the “lira rescue” policy. The opposition leaders and many well-respected economists, who had been warning about this crisis for several weeks, have raised many questions about the longer term risks associated with the “lira rescue” policy and they have also demanded an explanation about how it was implemented. They have pointed out that the balance sheet of the central bank shows that state-owned banks and the central bank had sold more than $8.5 billion during the first three days of the plan to support the lira. They have asked for full transparency about how and to whom this amount of foreign currency reserves were sold. They argue that the appreciation of lira in these three days was not a result of dollar sales by the public. Rather, it was a result of this massive sale of hard currency by the central bank.
For the health of the Turkish economy and for Erdoğan’s political future, the success of this plan is critical. If it fails and lira depreciates again, it will be very difficult to restore public confidence in the lira and larger depreciations are likely. The political survival of the AKP and Erdoğan will also depend on the plan’s success.
Erdoğan’s "lira rescue policy" was not the best way to stabilise the national currency but it is now a fact on the ground that all political actors and social groups have to come to terms with. Now they all should focus on how to make it successful in the long run. This is not an easy task under current political and economic conditions of Turkey, which like other nations has had to deal with the COVID-19 pandemic. Here are a number of steps and measures that can increase the plan’s likelihood of success.
Subordinate all other economic goals to price and exchange rate stability: So much is at stake for the Turkish economy that policymakers have to rethink their priorities and subordinate all other goals to preserving the value of lira. In recent years, Erdoğan has shown a willingness to tolerate inflation rates in the range of 10 to 20 percent per year for the sake of economic growth. Now the “lira rescue policy” will require a reduction in the inflation rate to the range of 0 percent to 5 percent per year, even if it leads to an economic slowdown in the short run. This requires painful adjustments to government spending and tax policies to minimise the budget deficit, which will require borrowing large sums from the central bank.
Restore central bank Independence: One of the major achievements of Turkey’s market-oriented economic reforms in the early 2000’s was the granting of independence to the Turkish central bank in 2001. This reform led to low inflation rates (under 10 percent per year) during 2004-2016. As Erdoğan eroded the independence of the central bank by replacing the directors that did not support his policies, the inflation rate increased. The most important requirement for the success of the “lira rescue” policy is public trust in the government's commitment to price stability. If Erdoğan restores the independence of the central bank, households and investors will have more confidence in the lira and their demand for dollar and euro savings will decline.
Return to a “zero problem” economy-oriented foreign policy: the Turkish economy is highly dependent on exports and inflow of foreign investment, which is sensitive to Turkey’s diplomatic and economic relations with the rest of the world.
In its early years in power, Erdoğan’s foreign policy gave high priority to promotion of trade and investment (known as “economic diplomacy”). Relations with Middle Eastern countries and Europe improved and Turkey was able to increase the inflow of foreign investment from these regions. He also expanded Turkey’s economic relations with China and Russia under the same vision. In the past ten years, there have been some setbacks in this “economy first” approach. In this interval, Turkey has experienced periodic tensions with most of its economic partners as Erdoğan has adopted a more interventionist and militaristic approach in Syria, Egypt, Libya and the eastern Mediterranean.
The current crisis demands a significant improvement in Turkey’s diplomatic relations with countries that have traditionally invested in Turkey. Fortunately, Erdoğan has demonstrated in the past that he is capable of mending relations and pragmatism in foreign policy. In recent months, we have witnessed some positive moves in this direction as Turkey has tried to improve its relations with Saudi Arabia, the United Arab Emirates and Egypt. There is now an urgent need to accelerate the campaign to build trust with current and potential economic partners for the sake of promoting exports and attracting foreign investment in the next twelve months.
Cooperation of opposition parties and independent experts: No one can blame the opposition parties for exposing the weaknesses and policy failures of Erdoğan’s economic policies to increase their own political popularity. They have been especially vocal during the last three months as the economic crisis has deepened. However, now that the government has managed to contain the crisis with its “lira rescue” policy, the opposition has a patriotic duty to adopt a competition-cooperation strategy.
As explained above, the success of this policy will depend on the confidence of the public and investors in the government’s ability to preserve the value of the lira. While criticising the government, the opposition parties must be mindful of undermining public confidence in the “lira rescue” policy. Despite believing that this was a less than ideal response, they must engage in constructive criticism on how to make it a success. In other words, they have a moral duty to view this as a national emergency that requires the cooperation of all political leaders to avoid an economic disaster.
The mainstream and seasoned economists that have warned the government about this crisis repeatedly must also adopt a similar attitude despite their disappointment and frustration with Erdoğan. If the government has the foresight and wisdom to form an independent emergency economic advisory committee and invite them to join, they must accept the invitation for the sake of the Turkish economy.