The writer is senior emerging markets economist at Capital Economics
Signs that newly re-elected Turkish president Recep Tayyip Erdoğan is willing to move away from unorthodox economic policies has led to an increase in investor optimism towards his country.
These developments are encouraging but investors should not underestimate the size of the adjustment that Turkey’s economy needs to make and the risk that Erdoğan reverses course before the policy shift really takes off.
Turkey’s economy is in desperate need of a policy adjustment. Low interest rates and restrictive foreign currency regulations have resulted in the build-up of large economic imbalances, including high inflation, a wide current account deficit and an overvalued exchange rate.
Rumours had been circling that Erdoğan may moderate his economic policies if re-elected. The appointment of Mehmet Şimşek as treasury and finance minister is the first convincing sign that a shift towards orthodox economic policymaking may be on the cards. Şimşek is highly regarded by investors and markets have reacted favourably to his appointment — the cost of Turkey’s five-year credit default swaps, which act as insurance against a sovereign default, has fallen sharply.
It’s unclear why Erdoğan has suddenly had a change of heart. Perhaps he has realised that current policy is unsustainable and that a strategy of growth at all costs is no longer needed with the election out of the way. Whatever the reason, officials are now working hard to rebuild credibility. Şimşek’s remarks over the weekend ticked a lot of boxes: commitment to fiscal discipline, price stability and reference to more “rational” policies.
If this is a real shift towards orthodoxy, credible steps need to be taken quickly. Among the first will be loosening policymakers’ grip on the currency. Various foreign currency restrictions and central bank interventions have been used to prop up the lira at an artificially strong level in recent months. These were successful ahead of the election, but have come with a cost: the central bank’s foreign exchange reserves, which were already at dangerously low levels, have fallen even further and Turkey has lost a lot of export competitiveness.
Policymakers wanting a sustainable turnaround in the current account and to attract foreign capital cannot hope to achieve this without a competitive exchange rate. Turkey needs a significant adjustment in the lira, both in nominal and real terms. A faster pace of depreciation would be a welcome sign that policymakers are easing back interventions and letting the currency return towards fair value. But the size of the required currency adjustment will be substantial. Inflation will be higher than otherwise and large and disorderly currency falls may cause strains in the private sector.
The next key step will need to involve a shift in policy at the central bank. A new central bank governor is a minimum. Whoever takes the job will need to be given the freedom to raise interest rates sharply. The experience in emerging markets is that it takes many years of high real interest rates to bring inflation back to single digits. Navigating the political hurdles to do it could prove a significant challenge.
All of this was hard to imagine a few weeks ago, but there are still unanswered questions. Will this be a half-baked policy shift in which interest rates are raised only gradually? Is it a temporary strategy to buy policymakers time while external financing strains remain so acute? Erdoğan’s abrupt sacking of central bank governor Naci Agbal in 2021, after he raised interest rates, is a cautionary tale about the dangers of getting too carried away with optimism on sensible appointments too quickly.
If Ankara embarks on a path towards orthodoxy, the medium-term outlook for the economy could be transformed. The lira’s decade-long depreciation largely reflects the wide gap between Turkish and global inflation rates and the excess that investors have demanded to compensate for holding the currency. Policies that reverse these trends have the potential to break Turkey out of the high inflation-currency depreciation trap that it has been in for years.
For now, a key focus is making sure that this policy shift sticks. So long as power is concentrated in Erdoğan’s hands, the threat that he calls an end to orthodoxy at any time will remain. This is likely to stay embedded in the risk premia on Turkish assets. If Erdoğan’s shift proves only temporary, Turkey goes back to square one. A severe currency crisis would become a bigger threat and this could ultimately cause major strains in the banking sector and, perhaps most worryingly, the public finances.