How Erdogan’s unorthodox views disrupt Turkish markets

Turkish President Recep Tayyip Erdogan isn’t the only politician who doesn’t like it when the country’s banks charge people a relatively hefty loan. What sets him apart is his unorthodox belief in low interest rates and his determination to wrest control of monetary policy from central bankers. The result: a series of policy rate cuts that fueled uncontrolled inflation and accelerated the currency’s collapse.

1. What is Erdogan’s problem with high interest rates?

He says they slow economic growth and fuel inflation. The thesis has been pissing off international investors for years. While the country’s spending and credit binge during the pandemic drove growth, the economy also suffered from double-digit inflation and unpredictable political moves. He also referred to Islamic usury bans as the basis of his policy.

2. Are your arguments reasonable?

The weakest point about growth is. When a central bank raises rates, banks are less able to borrow to hold reserve requirements and tend to lend at their own high rates. This makes business loans rarer and more expensive and therefore can slow the economy down. But Erdogan’s second notion – that high interest rates cause prices to rise – contradicts conventional economic theories.

3. What is the basis of Erdogan’s theory?

It is likely to be partly based on his experience managing businesses, mainly in the food sector, before his career as a politician took off. Many Turkish companies borrow relatively heavily to cover operating expenses, making volatility in borrowing costs a source of uncertainty and rate hikes an additional expense. According to Erdogan, higher tariffs translate into higher prices because companies have to pass on higher costs to their customers. This makes assumptions that orthodox economists contest, namely that interest rates make up a significant part of the costs of companies and that producers have sufficient pricing power to impose their will on consumers.

4. Who agrees with Erdogan?

The argument is based on a theory by Yale University economist Irving Fisher on the relationship between inflation, nominal interest rates, and real interest rates. Critics of neo-fishers argue that, even if their theory had merits, it would not apply to an economy like Turkey’s, which suffers from chronically high inflation and depends on foreign funding. This is because the interest rate cut reduces the return on investment in Turkish assets and the local currency tends to weaken when foreigners decide to put their money elsewhere. This increases the cost of imported goods in lira and results in higher prices or more inflation.

5. What did Erdogan do to put his views into practice?

Many central banks have increased borrowing costs to fight inflation after the pandemic. Turkey went the other way, cutting its benchmark interest rate by 7 percentage points to 12% in the 13 months to September. During that period the lira gradually weakened and inflation accelerated. The government raised the national minimum wage in December and July to limit the blow to families. This further inflamed prices, taking inflation to a 24-year high above 80% in August, the fourth highest among the 120 countries followed by Bloomberg. Erdogan held out, saying what Turkey needs are more investment, production and exports, not higher interest rates.

6. What is the impact on the financial markets?

Interest rates on commercial debt began to diverge from benchmark rates as lenders refused to offer ever cheaper loans when the central bank’s short-term financing offer was in doubt. In response, monetary authorities have imposed rules to force banks to bring lending rates closer to the benchmark. They were also obliged to increase their holdings of public debt at a fixed rate denominated in lire. As a result, the cost of lira debt declined, while Turkish junk-rated dollar bond yields went in the opposite direction.

7. What has it done to the economy?

Homes, cars and many essential goods have become inaccessible to a swath of Turkey’s 84 million inhabitants. Food inflation has hit low-income workers, while the middle class has seen a decline in living standards. On the other hand, economic growth outperformed that of Turkey and unemployment was relatively low due to the abundance of cheap labor. As the stock market rose, keeping pace with inflation, bond investors struggled to adjust to a world of 68% real negative yields. The lira hit an all-time low against the dollar in September, although the central bank spent about $ 75 billion this year to support the currency, according to Bloomberg Economics’ calculations.

8. Could Erdogan turn the tide?

Erdogan has signaled that he will do whatever it takes to keep his low rate policy intact. Finance Minister Nureddin Nebati told investors frustrated with low bond yields that they can find good returns in Turkish equities. With elections looming in 2023, Erdogan fears he will change course and risk a burst in lending rates that could inflict further pain on consumers. To bolster popular support, he announced a $ 50 billion project to increase home ownership, capped rent, canceled some student loans, and promised another big hike in the minimum wage. He is aware that the economy is his biggest challenge and economists are not ruling out a political rethink after the elections.

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