To Recep Tayyip Erdogan, Turkey’s president, it is pretty clear who should receive next year’s Nobel prize in Economic Sciences. Mr. Erdogan proved a widely held belief that high inflation can be tamed by raising interest rates wrong and that, actually, it is the other way around: by lowering interest rates inflation will disappear. Erdogan’s theory is groundbreaking and can be compared to Galileo’s theorem 400 years ago that the earth revolves around the sun, instead of the other way around. The Ottoman leader is now putting his theory in practice. With inflation running at 21.3% in November, Turkey’s central bank, on urging by the president (defying his wishes shortens the career of a central bank governor instantly, as we have witnessed), lowered its policy rate from 19% in August to 14% as of mid-December with the promise of more rate cuts to come.

Unfortunately, some economics-illiterate investors are still in denial. The lira dropped to 18.5/EUR after the latest rate cut from 9.1/EUR at the start of the year, whilst bond yields rose to 23.5% (coming from 13.1% in January) and FX forwards are trading at close to 30% implied yield. It doesn’t seem to worry Mr. Erdogan, who insists that a cheaper lira only would make Turkey more competitive abroad. Yes, exports might indeed accelerate but imports become dearer when expressed in lira. Turkish citizens are complaining that life is becoming more expensive as higher import prices (for food and energy, for example) are passed on to consumers. Thus, they demand higher wages, possibly setting off an inflationary spiral. Strangely enough, Mr. Erdogan himself announced an increase in the minimum wage, covering 40% of the working force, from TRY 2,826 per month to TRY 4,250 per month next year, a 50% increase, to help offset surging living costs. Why not cut policy rates by another 5% to fight inflation? Anyway, wage inflation could over time easily neutralize the competitiveness gained by the lira weakness. Furthermore, a weakening lira is not considered a good store of value. Indeed, more than half of deposits already are held in foreign currencies and gold. In order to lure back Turkish investors (foreigners have left the local market in droves), Erdogan announced a new scheme where lira deposits are protected from currency drops. Investors that hold lira deposits at Turkish banks for a period of at least 3 months are compensated by the treasury if the lira weakens against the dollar. The announcement led to a bounce in the lira (to 12.2/EUR) but this simply might have been the result of central bank intervention to the tune of USD 7 billion (the currency weakened again after the trade was accomplished). The currency-protected lira deposit scheme is effectively a further dollarization of the banking sector by stealth. It could stop Turks selling liras for dollars or euros (if they still have enough trust in the banking system), thereby lessening pressure on the lira, but it could also prove very expensive for the country’s taxpayers if the scheme is a success (i.e. a significant take-up in protected deposits) and the currency weakens further.

At least I survived Christmas…

In our view, it is unlikely that the currency-linked deposit scheme is sustainable. Assume that the scheme is successful in limiting further currency depreciation. Then, depositors would not lose on FX but would only receive 17% on their deposit (at Garanti BBVA, for example, for amounts in excess of TRY 500,000) whereas inflation is running at 21.3%. In real terms they still lose. To avoid such situation, inflation should recede quickly but wage increases and lagged pass-throughs of higher import prices most likely will preclude this. Inflation is also fueled by high credit growth, another hallmark of Erdonomics. In local currency terms, credit to the non-financial sector rose by 2.4 times over the last 5 years, compared to 1.5 times on average for Emerging Markets (excluding Argentina). If inflation is not under control (we think it easily can reach 30% in the first half of next year), the consequences for the government’s balance sheet will be severe. Turkey’s sovereign debt is 37.8% of GDP, according to IMF, seems low but in reality is much higher given off-balance guarantees, deficits at state-owned firms and the fact that new financing will be dearer. CDS spreads duly rose this year from 3.0% to 5.6% to reflect the heightened credit risk. Solvency risk, however, is probably not imminent but liquidity risk is, given the twin deficits (fiscal and current account) and hollowed-out FX reserves (net reserves are negative once borrowed money is stripped out). The only way out is to establish a credible and independent central bank whose first step should be to tighten monetary policy. But merely suggesting such policy step, as two former central bank governors recently did, apparently is a criminal offence. We believe that by foolhardy implementing Erdonomics, Turkey, again, will be brought on the verge of a balance of payments crisis. Mr. Erdogan risks leaving his fellow Turks out in the cold…