Turkey faces a financial reckoning after Erdogan's victory

After Recep Tayyip Erdogan secured his third victory in May’s presidential run-off election, the Turkish lira sank to a record low of 20 against the US dollar, reflecting uncertainty around his government’s unorthodox economic policies and whether they will change going forward.

In his victory speech on 28 May, the re-elected president committed to economic unorthodoxy, reiterating his unconventional belief that cutting interest rates would reduce inflation, despite economists generally recommending raising rates to combat it. He said that with interest rates as low as 8.5%, inflation would ease too.

His policy of keeping inappropriately low interest rates, which have been almost halved since the end of 2021, exacerbated soaring inflation that peaked at 85 percent late last year before dropping to 44 percent last month. The lira has lost more than 90% of its value over the past decade. The country’s economic slump is widely blamed on this policy.

"Although Erdogan faces a host of domestic challenges, first and foremost is an economy battered by slow growth, low reserves, and persistently high inflation that has eroded investor confidence"

Turkish citizens have complained of an acute cost of living crisis, which Erdogan attempted to alleviate by increasing the minimum wage and pensions for public workers shortly before the election as people struggled to buy basic goods and pay skyrocketing rents.

Moreover, the foreign trade deficit widened in the lead-up to the presidential vote amid political and economic uncertainty, and the central bank's foreign exchange reserves declined. In late May, the Turkish central bank’s net foreign reserves collapsed below zero for the first time since 2002.

In his third mandate, Erdogan faces a host of domestic challenges, though, first and foremost, an economy battered by slow growth, low reserves, and persistently high inflation that has eroded investor confidence. At the same time, Turkey needs to buy goods and raw materials on world markets.

Whether the Turkish leader will stick to his controversial economic approach, as he has signalled, or be prepared to turn to more conventional policies remains to be seen.

Through his unorthodox economic and monetary policy, Erdogan has obliged the country’s central bank to lower interest rates even more while inflation was already rampant. If he is set to continue to exert control over the central bank and its ability to counter rising prices, the local currency will remain under strain and inflation rates are expected to stay high.

The awaited cabinet reshuffle at the end of last week, which resulted in an almost complete replacement of the previous cabinet, saw the return of Mehmet Simsek, a former finance minister who’s known for his market-friendly policies, in charge of Turkey’s economic management. His appointment has indicated that Ankara could shift towards a more orthodox direction.

The nomination of the new finance minister, who enjoys international and domestic credibility, is likely intended to send a message of stability to the markets.

"Turkey has no choice but to return to rational ground" in its handling of the economy, he said in his early statements on Sunday, and added that it is vital for Turkey “to reduce inflation to single digits again in the medium term”. He also advocated for establishing “fiscal discipline” and ensuring “price stability”.

While Simsek’s comeback could give some reassurance to mainstream economists and help to attract foreign investment, it is unclear how the newly appointed minister and the head of state will reconcile their different visions over monetary policies. Whether Erdogan will accept a more pragmatic approach is also in question.

“President Erdogan didn’t give any signal throughout the electoral campaign or after his victory about going back to rational policies, then he surprisingly nominated Simsek. I’m a little sceptical that Simsek’s tenure will be long,” Ceyhun Elgin, a professor of economics at Istanbul's Bogazici University, told The New Arab.

“The big challenge ahead for the new economic administration will be to build confidence and credibility,” Omer Guler, an economist and former Turkish diplomat working at the Institute for Diplomacy and Economy (instituDE), told TNA, noting that domestic and foreign investors will want “some actions”.

He said that financial players will be keen to see the country's central bank acting independently from the government, and Simsek choosing names for key positions in the economy.

"I don't think Erdogan will restore economic orthodoxy. He will try to buy time because he has no room for manoeuvre for the Turkish economy. Then once price stability is achieved, he will go back to his old policies"

It will mainly depend on how much leeway the Turkish ruler will give the minister in the management of the economy, and for how long. Investors, who want Simsek to enjoy freedom in overseeing a broader economic policy, will be watching closely to see how much autonomy and authority he will be allowed, and if he will supervise or change economic-related personnel.

The Turkish president has full authority, with extensive executive powers and a parliamentary majority. Since 2021, his economic programme has stressed monetary stimulus and targeted credit to boost growth, exports and investments, placing the central bank under his tight control.

“Ultimately, Erdogan believes in low-rates, high-growth, low unemployment. He’s already signalled a willingness to drop FX interventions since the elections, and inflation-targeting has not been a primary concern for over a decade,” Emre Peker, a director at Eurasia Group covering Turkey's economy and politics, wrote on Twitter.

A largely cosmetic reset of current economic policies is more likely than a major U-turn on the part of the president. He may initially grant Simsek independence, letting him do what’s needed to fix Turkey’s economic troubles, though he may also later step in and quickly revert to his rate-cutting policy.

“I don’t think Erdogan will restore economic orthodoxy. He will try to buy time because he has no room for manoeuvre for the Turkish economy,” the instituDE’s economist contended. “Then once price stability is achieved, he will go back to his old policies”.

Guler predicted that, because leading positions in the country are typically filled by those close to the presidency who aspire to remain in those portfolios, the incoming finance chief will possibly face criticism from the ruling party for naming individuals “based on their competence” instead of “loyalists”.

Since Turkey adopted a presidential system, the chief of state holds the power to be the only decision-maker for public appointments such as directors of the central bank and top bureaucrats of the economic institutions.

In another move to revamp his economic team, Erdogan is expected to name a new head of the central bank in the coming days ahead of its next rate-setting meeting scheduled for 22 June. He is considering Hafize Gaye Erkan, a US-based senior finance executive, as a potential choice.

A rise in interest rates will be the first awaited step in a partial shift to a more traditional economic policy. Elgin anticipated that a policy rate hike would presumably be introduced in a gradual fashion following the monetary policy committee’s meeting later this month.

“What will be written down by the monetary policy committee after its next meeting in how it plans to go about raising interest rates will be more important than how much the increase may be,” he said.

The economics professor also argued for a progressive lifting of macroprudential measures, including limits on cash withdrawals and indirect state controls on the lira’s exchange rate against foreign reserve currencies.

"Erdogan doesn't really have other options. If he wants to continue with his original policy, and Simsek cannot affect an economic switch, the situation will explode in the late part of the year"

One of the “backdoor mechanisms” he referred to is a costly deposit scheme protected against the lira’s depreciation - accounting for close to a quarter of all Turkish deposits - that was launched at the end of 2021 amid depleted foreign currency reserves in a bid to keep the local currency valuable in the face of lower interest rates.

While many of these economic policy changes would help bring down inflation, they also have the effect of cooling down the economy and creating unemployment, something Erdogan can ill afford. That may well be cause for concern ahead of Turkey’s municipal elections planned for next spring and could lead to a rethink over these policies in the run-up to local polls.

Yet, without a policy re-adjustment, the current economic dynamics won’t sustain Turkey’s financial needs.

To ease its financial crunch, Ankara has relied on multiple currency and deposit deals from Gulf states and Russia in recent months. But it would need more foreign money inflows to manage its external payments, which is hardly sustainable.

Besides dealing with financial turmoil, Turkey is still recovering from a devastating earthquake in the south in February that killed more than 50,000 people and further compounded the country’s financial woes.

According to World Bank’s estimates, the devastation caused $34.2 billion in “direct damages”, and the recovery and reconstruction costs could add up to twice as much.

“Erdogan doesn’t really have other options. If he wants to continue with his original policy, and Simsek cannot affect an economic switch, the situation will explode in the late part of the year,” Elgin warned.

Alessandra Bajec is a freelance journalist currently based in Tunis.

Follow her on Twitter: @AlessandraBajec