Turkey’s Ceaseless Battle with Price Stability: Inflation and Currency Volatility

Less for more has become the unfortunate new reality for Turks. Inflation stands at a staggering 15%, with this expected to edge higher until April of this year. Food has become so expensive in Turkey that consumers consider stockpiling rice and pasta to avoid swallowing even higher prices in later months. In a world with near-zero inflation, Turkey stands out as an exception with annual consumer prices rising to 15% – a rate by far the highest in the OECD, and well above the central bank’s official 5% target.

Turkey’s inflation is largely attributable to the substantial depreciation of the lira. An attempted coup in 2016 and concerns of President Recep Tayyip Erdogan’s unorthodox resistance to high interest rates, despite sky-rocketing inflation, have disturbed investors. Re-elected in 2018, the president gave himself sole power to appoint Turkey’s central bank governor. His subsequent appointment of his son-in-law, Berat Albayrak, as finance minister was seen as a sign of Erdogan tightening his grip on power, exacerbating investor anxiety. Loss of investor confidence in Erdogan and the central bank are what have led to the lira’s unfortunate demise, losing half its value against the US dollar since 2016 (Oct 2018). This has entailed a vicious cycle – as the lira continues to depreciate, prices are pushed higher and investor confidence in a once high-flying emerging market is further eroded.

Depreciation in the Turkish lira has only intensified inflationary pressure. While rising oil and fertiliser prices and dry weather are partly responsible for the jump in food inflation to 20%, a weaker lira has hiked import costs on some $9 billion in food. While the pandemic-induced collapse in oil prices may alleviate some inflationary pressure, it is worth noting that Turkey is heavily reliant on imported oil, so rising oil prices, which are priced in dollars, have the potential to deal a severe blow to producers, who often pass on prices to consumers.

The tumble in the lira has proven particularly painful for Turkish companies with dollar and euro-denominated debts to service them. Squeezed companies such as these are less likely to be able to pay, leaving Turkish banks saddled with bad loans. This has already revealed weaknesses in Turkish companies that investors may previously have ignored, namely heavy short-term debt burdens and non-performing loans. Catalysed by the coronavirus pandemic, this has triggered foreign investors to withdraw capital from Turkish companies, instigating an exodus of Turkish assets in 2020.

Not only have investors lost confidence in the lira, but Turks themselves, too. As the value of the lira slumps, there has been a growing fondness among Turkey’s businesses and savers for foreign-currency deposits – a phenomenon known as ‘dollarisation’, that weakens the effectiveness of monetary policy. The proportion of Turkish bank deposits being held in foreign currencies such as USD and EUR hit the equivalent of TL 1tn at the end of March 2019, according to data from Turkey’s Banking Regulation and Supervision Agency, symbolically edging past the TL 993bn held in the country’s own currency.

Turkish authorities have subsequently made it more difficult for foreign financial institutions to trade the domestic currency and have imposed costs on foreign currency transactions to deter both businesses and savers from converting their lira to foreign currency. While such control may appear idealistic, it carries with it serious dangers for long-term economic health. Namely, imposing restrictions on financial institutions may reduce efficiencies as they distort their incentives to deploy resources in productive capacities.

Frequent policy changes also lead to unpredictability, discouraging long-term capital expenditure and inflows of foreign capital. With its young and entrepreneurial population and limited natural resources, Turkey needs foreign direct investment and technology transfer to catch up with more advanced economies. Inflows of foreign finance are also associated with improved managerial skills for the recipient country; thus, capital and management of resources have the potential to improve significantly with time.

Economists generally agree that higher interest rates are necessary to curb rising inflation. However, Turkish President Recep Tayyip Erdogan disagrees, firmly believing in the economically unorthodox view that interest rate hikes lead to only higher inflation. He supports cutting rates to boost economic growth and consumer expenditure,

especially following the pandemic-induced economic downturn – which, among other things, has paralysed Turkey’s tourism industry for the year; a critical provider of employment and much-needed foreign currency.

On balance, Turkey’s priority is to improve medium-term inflation, rebuild bank credibility and subsequently restore investor confidence in the lira. We have, in fact, very recently seen a sharp shift in investor sentiment that has come following Turkey’s shakeup of its economic management in November, leading to a rally in the lira of around 6.5% against the dollar since the end of 2020. With the recent installation of the new central bank chief, Naci Agbal, increased autonomy to deploy more orthodox monetary policies have enabled interest rates to be held at 17% in a serious effort to diminish the rapid inflation that had caused an exodus of foreign capital and dollarisation. To be effective, these efforts must be accompanied by targeted and predictable policy decisions, without exercising restrictive measures on free capital flow. Nevertheless, while economic growth takes a back seat, Turkey’s ceaseless battle with price stability continues.

This article was written by: Prerak Goel, currently a student at the London School of Economics, pursuing BSc Economics. 

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