The author of this article is Senior Emerging Markets Economist at Capital Economics
Investor optimism about his country has grown amid signs that newly elected Turkish President Recep Tayyip Erdogan is willing to abandon unorthodox economic policies.
These developments are encouraging, but investors should not underestimate the scale of the adjustment Turkey’s economy will need to make, and the risk of Erdogan changing course before the policy shift actually begins.
The Turkish economy is in dire need of policy adjustments. Low interest rates and restrictive foreign exchange regulations lead to serious economic imbalances, including high inflation, current account deficits, and overvalued exchange rates.
Rumors have been swirling that Erdogan, if re-elected, could moderate his economic policies. The appointment of Mehmet Şimşek as finance minister is the first convincing sign of a possible shift toward orthodox economic policymaking. Şimşek is highly regarded by investors and the market has responded favorably to his appointment – the cost of Turkey’s five-year credit default swap, which acts as insurance against a sovereign default, has fallen sharply.
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It was unclear why Erdogan had suddenly changed his mind. Perhaps he has realized that current policies are unsustainable, and that with the elections over, a growth-at-all-costs strategy is no longer needed. Whatever the cause, officials are now trying to rebuild credibility. Şimşek’s comments over the weekend ticked a lot of boxes: a commitment to fiscal discipline, price stability and references to more “rational” policies.
If this is a real shift to orthodoxy, sure steps need to be taken quickly. The first will be for policymakers to loosen their grip on the currency. Various foreign exchange restrictions and central bank interventions have been used to drive the lira artificially higher in recent months. These measures were successful ahead of the election, but they also came at a cost: the central bank’s foreign exchange reserves, already dangerously low, fell further and Turkey’s exports became less competitive.
Policymakers who want to achieve a sustainable improvement in the current account and attract foreign capital cannot do so without a competitive exchange rate. Turkey needs a major adjustment to the lira, both in nominal and real terms. A faster pace of depreciation would be a welcome sign that policymakers are easing intervention and returning currencies to fair value. But the size of the currency adjustment required would be enormous. Inflation would be higher than would otherwise be the case, and a sharp and disorderly devaluation of the currency could put pressure on the private sector.
The next critical step will require a policy shift involving central banks. A new central bank governor is the bare minimum. Whoever takes the job needs to be given the freedom to dramatically increase rates. Emerging market experience is that it takes years of high real interest rates to bring inflation back to single digits. Achieving this goal across political hurdles could be a major challenge.
All this was unimaginable just a few weeks ago, but there are still unanswered questions. Could this be a half-baked policy shift where interest rates are only gradually raised? Is this a temporary strategy to buy time for policymakers while external financing pressures remain so severe? Erdogan’s sudden firing of central bank governor Naci Agbal in 2021 after raising interest rates is a cautionary tale of the dangers of being too optimistic about sensible appointments too quickly.
If Ankara goes the orthodox path, the medium-term outlook for the economy could shift. The lira’s decade-long decline largely reflects the wide gap between inflation in Turkey and the world, and investors’ demands for compensation for holding the currency too much. Policies that reverse these trends have the potential to free Turkey from the high-inflation-devaluation trap it has been in for years.
A key focus now is to ensure that this policy shift is sustainable. As long as power is concentrated in Erdogan’s hands, there will be a threat of what he readily calls the end of orthodoxy. This is likely to continue to be embedded in the risk premium on Turkish assets. If Erdogan’s shift proves to be only temporary, Turkey will be back to square one. A severe currency crisis would become an even bigger threat, which could end up putting enormous pressure on the banking sector and, perhaps most worryingly, on public finances.