After spending the country’s FX reserves in a futile fight to defend the lira, Recep Tayyip Erdogan, Turkey’s president, finally gave in and sacked his pliant governor of the central bank, Murat Uysal on November 7th. Uysal’s removal was triggered by a freefall of the lira from 6.68/euro at the start of the year to 10.14 on 6 November. Erdogan replaced Mr. Uysal with Naci Agbal, the head of the presidential strategy & budget office. Mr. Agbal, someone with a sound economic background despite of being a close ally of Erdogan, served as finance minister between 2015 and 2018. The lira jumped when markets reopened after the weekend with investors apparently expecting a change in policy, which was promptly delivered when the central bank at last raised the policy rate from 10.25% to 15% on November 19th, in line with market expectations.
Uysal failed to raise rates but this was with the express consent (to put it mildly) of his “boss” Erdogan (the central bank is independent only in name), who believes that a high interest rate causes inflation. Uysal’s predecessor, Murat Çetinkaya, was dismissed in July 2019 after he failed to reduce the policy rate, then at 24% after Çetinkaya was forced to raise the rate from 17.75% in September 2018 to battle inflation and support the currency. Indeed, most broker analysts at the time thought that there was room to cut rates but Mr. Uysal did too much too quickly, further eroding investor confidence. Foreign holdings of lira-denominated government bonds is only 3.1%, according to Credit Suisse, down from 20% 3 years ago: a clear example of “original sin”, a situation whereby a country no longer can borrow from foreigners in its own currency due to lack of trust and monetary credibility.
Those were the days…
The replacement of the central bank governor came as a surprise to the market, but the bigger surprise was the resignation of Berat Albayrak, the finance minister and Erdogan’s son-in-law. Lütfi Elvan, a technocrat, was appointed as his replacement. Many Turks believed Albayrak was being primed to succeed Mr. Erdogan (earliest in 2023, more likely in 2033). Indeed, his nickname is “damat” or bridegroom, an ancient Ottoman title to describe men that entered the Ottoman dynasty by means of marriage of an Ottoman princess. Mr. Erdogan, a devout Muslim who values family ties highly, put his son-in-law in the all-important position of finance minister. Unfortunately, Mr. Albayrak listened too much to the wacky economic theories purred by his father-in-law at the dinner table. In September, when the lira came under heavy pressure, he exclaimed to a group of reporters that “the exchange rate is not important to me, I’m not looking at it”. Even though Mr. Albayrak seemed snooty about the exchange rate, the central bank spent US$ 140 billion over the last 2 years to defend the currency, according to estimates by Goldman Sachs. Mr. Albayrak must be an aficionado of smoking a water pipe as at the same meeting, whilst presenting the 3-year economic plan, he said that the economy would grow by 0.3% and inflation would slow to 10.5% in 2020. Instead, the IMF reckons the Turkish economy will contract by 5% this year whereas inflation could be around 12% (there are some doubts about the reliability of inflation reporting by the government), providing little pick-up if any for investors in terms of real yields.
The upside of a weakening lira is that it should make Turkish exports become more competitive and should help to push growth higher. However, the current account swung back into a deficit, projected at -3.7% for this year. This is most likely caused by low tourism revenues (hospitality accounts for 20% of exports) and by gold imports. A weak current account is obviously not helpful for the currency. In addition, the fiscal balance is decidedly in deficit (-7.9% for both 2020 and 2021 according to IMF with primary deficits at around 5%), increasing funding needs and public debt levels (40-45% and probably higher if off-budget guarantees and financing structures are included). Twin deficits generally are not a good development for credit quality, even though the covid-19 pandemic is partly to blame for this. Credit rating agencies are getting worried about the financial position of Turkey. In September, Moody’s downgraded the sovereign to B2.
Turkey’s economy by now is in a very precarious situation, facing an imminent balance of payment crisis. Fortunately, the solution is relatively simple but painful. First, the government should adopt orthodox and consistent macroeconomic and monetary policies. This month’s rate hike is a good start but more needs to be done. Increasing the 1-week repo rate, the official policy rate, by 475 basis points looks decisive but this rate really has not been used for lending for some time already. Instead the overnight repo rate is used which stood at 14.75%. However, the signal it provides to investors is positive. The currency should not be supported by FX interventions by the central bank. This is easy to do because the central bank ran out of money (its net reserves are actually negative). Inflation may spike but will gradually come down as unsustainable credit growth peters out (subsidized lending by state banks should also be reduced) due to higher interest rates. A credible fiscal consolidation plan should be put forward to ensure that debt levels remain sustainable (although Turkey’s problem is more one of liquidity than solvency, certainly if compared to peers). The price for economic mismanagement is higher unemployment and a spike in corporate defaults. Refinancing needs are high (about 25% of GDP in the next 12 months), so execution of the plan is both urgent and risky. But Turkey fundamentally has a vibrant economy as well as a young and entrepreneurial population. With the right policy mix, the Turkish economy can and will flourish.
Mr. Erdogan seems to understand that a rate hike is required to contain the financial crisis. But at the same time there is a risk that, yet again, he will return to his beloved low-interest rate policy to fight inflation and stimulate short-term economic growth, setting the stage for the next credit crunch. Maybe better when he keeps his wacky economic theories in the family and let Messrs. Agbal and Elvan get on with the job …