How Erdogan’s Unorthodox Views Rattle Turkish Markets

Turkish President Recep Tayyip Erdogan isn’t the only politician who doesn’t like the country’s banks charging relatively high fees for borrowing. 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 interest rate cuts that have fueled runaway inflation and caused the currency to collapse.

1. What is Erdogan’s high-interest beef?

He says they slow economic growth and fuel inflation. The thesis has unsettled international investors for years. While the country’s spending and credit glut during the pandemic has fueled growth, the economy has also suffered from double-digit inflation and unpredictable policy measures. He has also referred to Islamic prohibitions on usury as the basis for his policies.

2. Are his arguments reasonable?

The point about weaker growth is. When a central bank raises interest rates, banks are less able to borrow to maintain mandatory reserves and tend to lend at their own increased interest rates. This makes borrowing rarer and more expensive for businesses, which can slow down the economy. But Erdogan’s second thesis, that rising interest rates cause prices to rise, contradicts conventional economic theories.

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

It is likely that this is based in part on his experience running companies, mainly in the food industry, before he began his career as a politician. Many Turkish companies borrow relatively large amounts of money to cover operating costs, making volatility in borrowing costs a source of uncertainty and interest rate hikes an additional cost. From Erdogan’s point of view, higher rates lead to higher prices, since companies have to pass on the increased costs to their customers. This makes assumptions that orthodox economists challenge, namely that interest rates account for a significant portion of companies’ costs and that manufacturers have sufficient pricing power to impose their will on consumers.

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4. Who agrees with Erdogan?

The argument is based on a theory put forward by Yale University economist Irving Fisher about the relationship between inflation, nominal interest rates and real interest rates. Critics of neo-Fischer supporters say that even if their theory were valid, it would not apply to an economy like Turkey, which suffers from chronically high inflation and relies on foreign financing. That’s because interest rate cuts reduce returns on investments in Turkish assets, and the local currency tends to weaken when foreigners put their money elsewhere. This increases the cost of imported goods in lira, leading to higher prices or more inflation.

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

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Many central banks have raised borrowing costs to fight post-pandemic inflation. Turkey has gone the other way, cutting interest rates by 7 percentage points to 12% in the 13 months to September. During this period, the lira gradually weakened and inflation accelerated. The government raised the national minimum wage in December and July to limit the impact on households. That has pushed prices higher, pushing inflation to a 24-year high of over 80% in August — the fourth-highest among 120 countries tracked by Bloomberg. Erdogan stood his ground, saying Turkey needs more investment, production and exports, not higher interest rates.

6. What was the impact on the financial markets?

Interest rates on commercial debt began to deviate from benchmark rates as lenders refused to offer increasingly cheap credit when the supply of short-term central bank funds was in doubt. In response, monetary authorities enacted rules to force banks to move their lending rates closer to the benchmark. They were also required to increase their holdings of lira-denominated fixed-rate government bonds. As a result, the cost of lira debt fell while yields on junk-rated Turkish dollar bonds went in the opposite direction.

7. What has it done to the economy?

Houses, cars and many essential goods became unaffordable for part of Turkey’s 84 million inhabitants. Food inflation hit low-income earners while the middle class experienced a drop in living standards. On the other hand, economic growth has outperformed Turkey’s competition and unemployment has been relatively low due to the abundance of cheap labour. As the stock market rallied and kept pace with inflation, bond investors struggled to adjust to a world of 68% negative real yields. The lira hit an all-time low against the dollar in September, despite the central bank spending an estimated $75 billion this year to support the currency, according to Bloomberg Economics calculations.

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8. Could Erdogan reverse course?

Erdogan has signaled that he will do whatever it takes to maintain his low interest rate policy. Finance Minister Nureddin Nebati told investors frustrated by low bond yields that they could find good returns in Turkish stocks. With 2023 elections looming, Erdogan is wary of changing course and risking a spike in lending rates that could inflict further pain on consumers. To bolster popular support, he announced a $50 billion home ownership project, introduced a rent cap, scrapped some student loans and promised another big minimum wage hike. He is aware that the economy is his biggest challenge, and economists do not rule out a political rethink after the election.

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