What Erdogan’s unusual economic ideas mean for Turkey

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Turkish President Recep Tayyip Erdogan isn’t the only politician who doesn’t like the country’s banks charging people relatively heavily to borrow money. 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 succession of benchmark rate cuts that fueled runaway inflation and precipitated a currency crash.

1. What is Erdogan’s beef with high interest rates?

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

2. Are his arguments reasonable?

The point on weaker growth is. When a central bank raises rates, banks are less able to borrow to maintain required reserves and tend to lend at their own high rates. This makes business loans scarcer and more expensive and can therefore slow the economy. But Erdogan’s second notion – that high interest rates lead to higher prices – contradicts conventional economic theories.

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

It is likely that this is partly based on his experience running businesses, primarily in the food industry, before his career as a politician took off. Many Turkish companies borrow relatively heavily to cover operating expenses, making volatility in borrowing costs a source of uncertainty and rate hikes an additional expense. According to Erdogan, higher tariffs lead to higher prices because companies have to pass on the increased costs to their customers. This makes assumptions that mainstream economists dispute, namely that interest rates are a large part of business costs and that producers have sufficient pricing power to impose their will on consumers.

4. Who agrees with Erdogan?

The argument is based on a theory by Yale University economist Irving Fisher on the relationship between inflation, nominal interest rates, and real interest rates. Critics of the neo-fishermen say that even if their theory had merit, it would not apply to an economy like Turkey’s, which suffers from chronically high inflation and depends on foreign funding. Indeed, the reduction in interest rates reduces the return on investments in Turkish assets and the local currency tends to weaken when foreigners decide to put their money elsewhere. This increases the cost of imported goods in liras and leads to higher prices, or more inflation.

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

Many central banks raised borrowing costs to fight inflation after the pandemic. Turkey went the other way, cutting its benchmark interest rate 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 hit to households. This further inflamed prices, sending inflation to a 24-year high above 80% in August – the fourth highest among 120 countries tracked by Bloomberg. Erdogan held firm, saying what Turkey needs is 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 were reluctant to offer ever-cheaper loans when the supply of short-term central bank funding was in doubt. In response, monetary authorities imposed rules to force banks to bring their lending rates closer to the benchmark. They were also forced to increase their holdings of fixed-rate government debt denominated in lira. As a result, the cost of lira debt fell, while yields on risky Turkish dollar bonds moved in the opposite direction.

7. What did it do to the economy?

Homes, cars and many essentials have become unaffordable for some of Turkey’s 84 million people. Food inflation has hit low wages, while the middle class has seen its standard of living shrink. On the other hand, economic growth outpaced Turkey’s peers and unemployment was relatively low due to an abundance of cheap labor. As the stock market rallied, keeping pace with inflation, bond investors struggled to adjust to a world of 68% negative real returns. The lira hit an all-time low against the dollar in September, even though the central bank has spent around $75 billion to prop up the currency this year, according to calculations by Bloomberg Economics.

8. Could Erdogan back down?

Erdogan signaled that he would do everything in his power to keep his low interest rate policy intact. Finance Minister Nureddin Nebati told investors frustrated by low bond yields that they could find good returns in Turkish stocks. With the 2023 election looming, Erdogan fears changing course and risking a spike in borrowing rates that could inflict more pain on consumers. To bolster popular support, he announced a $50 billion plan to boost homeownership, introduced a cap on rents, scrapped some student loans and promised another big hike in the minimum wage. He is aware that the economy is his biggest challenge, and economists are not ruling out a policy overhaul after the election.

More stories like this are available at bloomberg.com

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