By Marco Zecchillo, Head Researcher GEO – Economics
Abstract
The presidency of Recep Tayyip Erdogan in Turkey could be summarised, in economic policy, by the application of the so-called “Erdoganomics”. In monetary and fiscal terms, recent developments have lead to high inflation and expected growing interest rates. The debt of Turkey shows an upward trend, driven by infrastructure investment in the past years, but the beneficial effects of higher spending have been concentrated on key urban areas, Istanbul in primis, exacerbating cross-regional inequality. The latter may be associated, in econometric terms, to under-achievements in GDP performance. Coupled with high interest rates, the symptoms are present for a crisis. Markets may see Turkey as unable to service its debt in the future, also in the context of declining domestic output, correlated to a reduction in tax revenues. Problems may arise, amongst many others, when considering the erosion of the independent mandate of the TCMB (Central Bank of Turkey), which generally viewed low to moderate inflation as an objective. This may trigger a cycle characterised by a systematic inflationary bias to relieve the service cost. But, when matched by rising rates, the policy conversely makes debt more burdensome.
1. General Trends in the Turkish Economy
The following lines will discuss the trends for the Turkish economy in Government Debt to GDP, Current Account Balance (expenditures – revenues as a percentage of GDP) Ratio, Inflation Rates, Interest Rates and overall GDP. The idea is that, according to mainstream economic theory, higher rates of nominal output growth (i.e., real growth plus the inflation rate) may allow a country to run higher deficits to keep the overall Debt to GDP ratio in a stationary state, according to the formula:
For which Gamma equals to the real rate of output growth, Pi equals the inflation rate. The last parameter relates to the overall Debt on GDP Ratio in the previous period.
The Turkish economic growth has been pushed forth by systematic deficit spending which was funnelled conspicuously towards the infrastructural sector (Goyal, 2022), which is, per se, often a long-term investment. The hope, for an infrastructure-driven growth, is that the net present value of the investment undertaken in the present may payoff in the far future, and be higher than the initial outflow of money, keeping track of the dissipating value of money across time and the depreciation or amortisation of the assets (the former gets discounted by a function of the interest rate and an exponential factor for each subsequent period).
Despite these expectations, Turkey’s output entered a phase of stagnation and even decline, pressured to the bottom by huge internal and region-to-region imbalances. The city of Istanbul, as it is imaginable, has retained a lion share of these investments, while other areas have seen improvements to a smaller extent, such as the inner regions of the country (especially around the cities of Diyarbakir and Erzurum) (Kaya, 2018). This aspect could have exacerbated additional inequality and the increase in relative power of Istanbul over the rest of Turkey, Ankara included. In econometric analyses, the latter phenomenon was found to be associated to a negative effect on growth, and less durable persistence of the latter (Ostry, 2014). GDP reached its historical peak in 2013 (narrowly short of 1 trillion dollars), and never resumed growing (at the time of writing, the last figure for 2021 showed a value of 800 trillion USD) (World Bank, 2022), following the trend of other states in its neighbourhood, but with a lag with respect to Greece (5-year lag) and Iran (1-year lag). Reasonably, a lower growth rate of GDP enlarges the interest rate to growth differential, theoretically associated to a narrower room for manoeuvre to run deficit policies, without increasing debt.
The trends for the interest rate fluctuations appears more ambiguous and difficult to trace. While it reached astonishing levels in the early 2000s, it has undergone a significant decline until 2017. Since then, disturbances appear and a general rising trend may be hypothesised, at least since 2018, but the means for testing seem to be lacking, given unforeseeable variables at play (Central Bank of Turkey, 2022). It is, at the time of writing, 14%, higher than the 2018 value (8%), but lower than 2019 (24%). The inflationary phenomenon, when uncorrelated to increases in rates to dissuade borrowing (thus, lowering credit creation and putting downward pressure on inflation), may be dangerous for a variety of reasons treated in the next sections.
The path of inflation is much less ambiguous. As far as data display, the inflation boom seems to have occurred with some years of lag with respect to the potential rise of interest rates. This is, per se, peculiar. Generally, higher rates are a policy-derived outcome to inflation: to lower prices, the bank sells its obligations, which brings yields up. The inversion contributes in making the picture of the Turkish economy much more ambiguous and unintelligible.
CPI (Consumer Price Index) is expected, in 2022, to jump by 73.5% (note that CPI generally overestimates actual year-end inflation) with respect to 2021 (Turkish Statistical Institute, 2022), driven by food prices (plus 92% year-on-year) and energy, as an outcome of the Ukraine War and the post-pandemic resumption of aggregate demand (Turak, 2022).
The expectations for the future of Turkey, given all these factors, suggest that optimism should be avoided, for a variety of reasons hereby given.
2. Political Economy of the Erdogan Presidency
The President’s primary aim has been that of keeping interest rates low (Ersoz, 2022). Thus, the credit expansion phenomenon may be expected to continue, which allows us to foresee that the inflationary phenomenon is to remain. This signals a departure from the reformed mandate of the Turkish Central Bank (the new course initiated in 2002), pushing for an “Inflation Targeting Regime” to enhance the stability of the Lira. However, recent pressures on the independence of the Central Bank could trigger the perverse relationship that is created when a bank purchases government debt excessively: it expands the money supply. In addition to this, it makes both parties vulnerable to each other, given their interdependence. If the government defaults, the bank loses. If the bank goes into distress, government debt is sold on the market, likely making its price plummet, and its yield skyrocket.
3. Sources of Inflation in Turkey: TCMB Dependence and M1/M3 Growth
Turkey’s recent inflationary turn is just one aspect in a decade characterised by the presence of underlying trends that may worsen the future situation of the country. Inflation could, in mainstream theory, be understood as a monetary phenomenon. Nevertheless, its nature has strong roots in the fiscal policy of a country. A strand of thought ties the presence of a deep inflationary bias to the existence of high levels of debt (Easterly, 1990). The direct link between the government’s willingness to reduce debt and the increase of money supply operated by a Central Bank underlies a possible erosion of its independence, given that the banking system succumbs to the pressures of the executive. For instance, a bank enlarges the money aggregates supply (M1 and especially M3: these aggregates relate to actual currency circulating in the economy and more long term deposits held in banks) to purchase government debt, in the form of bonds, and releases liquidity in the economy. As it was expected, the Central Bank of Turkey (Turkiye Cumhuriyet Merkez Bankasi, from now on TCMB) was seen, by some commentators, as losing the grip on its independent mandate (Ahmadi, 2022).
While it has demonstrated the ability to withstand inflationary pressures by committing to an inflation target, recent developments have shown a potential policy reversal, allegedly triggered by governmental meddling in monetary affairs. Before, the TCMB could be regarded both as goal and instrument-independent: it sets its own policy goals and implements them. This is, for example, different from the Bank of England (instrument-independent only: the government sets the targets) and the European Central Bank (goal-independent, but narrowly instrument-independent provided the inability to act as a Lender of Last Resort and to operate in the Primary Financial Market, de iure). President Erdogan has, as a matter of fact, tightened its hold over the institution, by loosening key policy requirements and nomination procedures to reach the higher tier of its governance. For example, the President has actively removed two governors, allegedly justified by disagreements on the future course of interest rate policy (Foreign Policy, 2022). While the TCMB has managed to keep inflation at a relatively low level (thus, not requiring swift interest rate operations to restore the balance – i.e., higher interest lowers demand for credit. Thus, it tends to contain inflation rates: interest and price appear to interact in a negative relationship), the recent change in policy promoted by Erdogan pushes the institution to find a balance between high inflation and low rates (Washington Post, 2021).
These appear as two unattainable goals, at least simultaneously. To reach this aim, mandatory capital buffers requirement were relaxed, allowing banks to issue equal credit, but with less deposits. While this may work in maintaining the credit market open, it increases the riskiness of banks, which may itself make interest rates skyrocket. The market might sense Turkish banks having become more risky, which renders them vulnerable to dry-ups and scrambles for cash, in the event of bank runs (for instance, they may run out of funds when depositors wish to massively withdraw their money, in the unlucky event of a crisis)
By analysing intertemporal data, Turkey’s money stock has undoubtedly increased (Statista, 2022), possibly as a way to curb the ascending path of debt to GDP, as previously discussed.
As a matter of fact, expanding money supply might cause the currency to be devalued, triggering a phenomenon of currency depreciation, which weakens the purchasing power of wages. On the contrary, an internal devaluation of the currency could boost competitiveness, but the costs in terms of general wellbeing of the population and the risk of experiencing a reserve crisis (due to excessive outflows of foreign reserves) may be regarded as too high, especially for the political cost attached in terms of leader appreciation rates.
Excessive inflation reduces the purchasing power of citizens, given that wages are less mobile and take discretionary policies to be adjusted. To reduce the inflationary spiral, interest rates shall be risen, but rising interest rates might dry up the credit market: banks would struggle more to find investors, they lose the ability to roll over their investment and they could find themselves obliged to sell (deleverage) to avoid entering distress. Rising interest rates makes debt itself more risky: this may set in motion a market panic spiral and a self-fulfilling prophecy. Debt, if it is expected to become unsustainable, it does become unsustainable.
4. The Perverse Interest Rate to Debt Relationship: Why Turkey Risks
As previously discussed, Turkey’s debt may still, at the time of writing, be short of unsustainability. However, some underlying trends allow us to speculate that it may not remain as such indefinitely, given the current historical moment of uncertainty in world economics. The resumption of demand after the, hopefully, worst part of pandemic and the supply chain risks associated to the War in Ukraine have contributed to rising inflation, but also to rising yields. The potential harmful effects are manifold, when this materialises.
As previously analysed, Turkish debt to GDP ratio is soaring again. While the country had managed to reduce the debt from 75% in 2001 down to 27.4% in 2015, the trend has undergone another uptick, reaching 42% in 2021. Taking back the reasoning of this paper, it may be argued that debt reduction inherently relies on the maintaining of interest rates at an acceptable point, when spending cuts are an undesirable or unviable option. Indeed, Turkish government spending has always increased since when data are available (2000-2021) (Turkish Statistical Institute, 2021). To repay its debt, a government needs, therefore, to ensure that interest rates remain low to make the servicing on previous debt less costly, both in terms of actual money and in terms of risk. However, it appears as a policy option that executives cannot directly control.
Debt servicing relates to the product of the interest rate at that point in time and the overall size of the debt: if all servicing expenditures are completed, debt does not grow. Generally, this product is regarded as the fraction of national income that needs to be devolved to repaying debt. However, if the Debt/GDP spirals out of control and the interest rises, at is expected due to market fears, the burden on taxpayers tends to grow. As a matter of fact, a large part of national income shall be collected into taxes just to service debt. If a government is unwilling to increase the tax rate, it shall cut spending on welfare and other internal policies, to make room for debt. Provided that this is not always politically feasible, on the side of a leader, debt remains unserviced and keeps on growing indefinitely, in a vicious cycle of even higher interest, panic and loss of credibility.
Fortunately for Turkey, debt is still contained. However, its interest rate of 14% sets the country in a less favourable position, with a potentially worsening outlook. Its current one may be deemed as more risky than European countries, such as Italy, with heavier debt burdens but lower cost of servicing debt overall, provided lower rates. The European Central Bank, via its massive purchases, has been able to lower spreads and offer stability, at the same time safeguarding inflation, despite M3 growth, at least until 2021. The recent upward tick of European Union countries’ interest rates seems to signal that the “honeymoon” could have finished. However, at the time of writing, not enough evidence of a reversed course of policy is present.
The question to debate is, instead, whether the TCMB could be able to carry out similar policies, in the case Turkish debt enters into a situation of distress, as it was for Europe almost a decade ago. And, most importantly, whether it will be able to phase out the measures in the future without macro disturbances on the economy.
5. Conclusion
Gloomy perspectives may face Turkey in the next years, if the trend of rising debt and rising interest rate is not halted. The latter, is conditional on the avoidance of market panic. However, the commitment of Erdogan to keep rates low, which incentivises borrowing and debt increase, may further lift inflation. However, the inflationary bias, as previously discussed, may even reduce actual debt, but with huge disturbances all over the economy. It appears as a pro-cyclical policy, which does not contribute in halting the fears of Turkish citizens. A weakened currency, in this historically uncertain moment, may expose the country to unforecasted impacts and sudden foreign reserve drought. These events are linked to the evolution of the pandemic in a country with a relatively low vaccination rate (that does not ensure against a virus return during Autumn 2022, with the power it had in late 2020) and the War in Ukraine (seen the contiguity of Turkey with the Black Sea, now under an increased Russian presence after the earlier moves in Georgia and current war in Southern Ukraine).
Sources
Ahmadi S. (2022). Autocrats are Exploiting Covid-19 to Weaken CB Independence. In “Analysis”, Foreign Policy, full article. B-2
Aydintasbas A. (2021). What is Wrong With Turkey’s Economy?. In “Global Opinions”, The Washington Post. Washington, USA. Full article. B-1.
Ersoz B. (2022). Erdogan Economic Policy as Inflation Rises, Currency Shrinks. VOA. Washington, USA, full Article. B-2.
Goyal D. (2022). Turkey. The Trouble with Debt-Driven Growth. In “Enterprising Investor”. CFA Institute, Charlottesville, Virginia, full article. B-2.
Ostry, J.D. (2014). Redistribution, Inequality and Growth. IMF Staff Discussion Note 14/02. IMF, New York, New York, pp. 7-11. B-1
Quinn C. (2022). Erdogan Economic Experiment Continues. In “Morning Briefs”, Foreign Policy, full article. B-2
Turak N. (2022). Turkey Inflation Soars to 73%. CNBC. Fort Lee, New Jersey, full article. B-1.
Data on Turkey’s Economic Fundamentals gathered from: www.tradingeconomics.com/Turkey/indicators . B-1
Data on Turkey’s Money Stock gathered from: www.statista.com/outlook/co/economy/Turkey. B-1.
Data on GDP gathered from: www.data.worldbank.org. A-1