Erdoğan’s monetary misadventures are pushing Turkey off course

Turkey’s presidential election run-off takes place this Sunday with the incumbent, Recep Tayyip Erdoğan, likely to win the election. He has not left victory to chance, practising monetary and regulatory manipulation right up to polling day to delay an all-too-possible financial crisis till after his return to office.

Erdoğan has subverted monetary policy for more than a decade now by leaning heavily on the central bank to hold down rates despite rocketing inflation, which hit a 24-year high above 80 per cent last October. He has tried to relieve the inevitable downward pressure on the exchange rate with an increasingly baroque series of interventions. Last week, it was revealed that Turkey’s gross foreign exchange and gold reserves dropped by 15 per cent in the six weeks leading up to the first round of voting on May 14. Net of borrowing from banks, the reserves are perilously near zero.

Among other expedient fixes, his government has tried to stop investors fleeing into dollar-denominated bank accounts by compensating holders of lira-denominated bank accounts against falls versus the dollar, thus building up dollar liabilities for the public sector. Most emerging market governments have tried to reduce dollar-denominated liabilities — India and Brazil’s sovereign debt is now almost entirely in local currency — but Turkey’s have been rising.

Yet despite monetary irresponsibility from an increasingly autocratic president, a growing culture of corporate cronyism and the flaws of governance evident in the response to the recent earthquake, Turkey has proved — thus far — to be a strong enough trading economy to weather self-inflicted damage.

It’s interesting to compare Turkey to Brazil. Around the turn of the millennium, the financial markets drove both countries off unsustainable currency pegs. Both then avoided a damaging debt default via tough IMF-backed fiscal tightening programmes conducted by heroic finance ministers, respectively Kemal Derviş (who, poignantly, died this month a few days before the first-round election) and Pedro Malan.

Since then, Brazil has stayed closer to macroeconomic orthodoxy. In contrast to Turkey, it has maintained a strongly independent central bank running tight monetary policy, mindful of the country’s history of hyperinflation.

But Brazil has remained primarily an agricultural exporter vulnerable to fluctuating global commodity prices and uncertain demand from China. Turkey, whose per capita gross domestic product measured by purchasing power parity has risen to about twice Brazil’s, has a highly efficient manufacturing sector, boosted by strong foreign direct investment inflows. Its companies sell into the rich consumer markets of the EU, to which it is anchored by a customs union for industrial goods.

Despite its eccentric monetary policy, the Turkish economy has delivered good growth, its per capita GDP rising from below 40 per cent of the OECD average in the mid-2000s to more than 60 per cent.

Manufacturing is usually the best way for middle-income economies to reduce poverty on a large scale. In Turkey, the manufacturing sector was 22 per cent of GDP in 2021, more like an east Asian economy (China is at 27 per cent, Malaysia at 23 per cent) than Brazil (10 per cent) and India (14 per cent).

But unlike the traditional east Asian pattern, Turkey’s manufacturing exports do not depend on undervaluing the exchange rate or suppressing domestic consumption. It runs a chronic trade deficit rather than a surplus. As veteran emerging markets analyst Karthik Sankaran notes, Turkey is exempt from the usual critique of the east Asian export-oriented model — prospering by currency mercantilism, sapping demand from trading partners.

Turkey is fortunate in its geographical location next to the EU, which, together with the UK, buys about half its exports — and near the Gulf states, whose governments have helped bolster its foreign exchange reserves. And Turkey’s open trade regime, certainly towards the EU, is one of the areas that Erdoğan’s destructive economic antics have left relatively undamaged — a testament to the beneficial pull of the bloc’s economic gravity. (This is also exactly what Vladimir Putin feared was happening in Ukraine, prompting the 2014 annexation of Crimea.)

By contrast, Brazil is a member of the dysfunctional customs union Mercosur and persists with goods tariffs in an attempt to protect its industry. India, even under supposed globaliser Narendra Modi, has also wrongheadedly raised tariffs to encourage domestic supply chains. Turkey’s standard applied non-agricultural goods tariffs at the World Trade Organization average 5.8 per cent, as opposed to 13.8 per cent for Brazil and 14.9 per cent for India.

That’s the good news. The bad is that this model is now threatened by Erdoğan’s monetary misadventures. Volatile inflation and exchange rates and regulatory interference deter domestic and international companies. FDI has tailed off in recent years, and the economy’s convergence with other OECD countries has stalled since around 2015.

As Sankaran notes, the economy’s underlying strength means Turkey could come through financial crisis and start growing relatively quickly. But resuming the country’s journey towards prosperity will mean Erdoğan backing off his financial and monetary chicanery. That’s a long way from a safe bet. There’s a lot of ruin in a nation, as the great economist Adam Smith said. Turkey’s current and probable next president seems intent on finding out just how much.

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