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Snap-elections called for snap-promises, but can Erdoğan keep them?

In 2001, the Turkish economy collapsed in an extensive crisis also known as “Black Wednesday”, the most impactful economic crisis in the modern Turkish history. The overnight interest rates rose up to as high as 7,500%, stock prices plummeted by approximately 15% and many were left without a job. Political instability, extensive domestic capital outflow, and high interest rates along with the devastating 1999 Marmara earthquake were the biggest issues leading to the crisis. Today, strikingly similar circumstances that are believed to have contributed up to 2001 are recurring in Turkey, creating an atmosphere of uncertainty and worry as the Turkish lira keeps hitting new lows against the USD and the Euro.

The Turkish lira recently hit a historical low of 4.9200 to the USD, reflecting a devaluation of approximately 30% against the dollar in 2018 so far. In addition to that, the current deficit is highly concerning. The Moody’s report have presented that Turkey has the biggest current account deficit among all emerging economies, equivalent to 4.5% of the country’s GDP in 2017. Turkey’s geopolitical position is not helping the trends in the economy either, the ongoing Syrian war and the refugee crisis, the recent US sanctions to its neighbor Iran, and continuous conflicts of interests with its allies are all factors that bring greater perceived risks to the table.The “governorship of region in a state of emergency” (OHAL), which enables further power to the president, has been extended for the 7th time in April, following the failed coup d’état of 2015.

However, over the devaluation of the lira, Erdoğan has consistently necessitated a looser monetary policy, claiming that it is what the Turkish economy requires for growth and new jobs created through investment. His regular “comments” on monetary policy have led many to believe that the independency of the CB was impaired. Constant pressure by the government officials backing Erdoğan’s claims seem to eliminate the interest rates as a tool to combat high inflation and high exchange rate volatility for the so-far-unresponsive CB.

The initial date set out for the 2019 presidential and parliamentary elections were moved up to June 2018. Erdoğan recently promised lower interest rates as a part of his election campaign, suggesting that higher interest rates are the root of Turkey’s inflation problem.

Due to higher country and currency risks, the Turkish market is received by investors as more risky and volatile than before. This is believed to be the main reason that the Turkish lira devalued significantly over the recent years. The depreciation of the currency was disadvantageous mainly because of deepening the already significant current account deficit, as well as readjusting the prices of exports as significantly more expensive. Combination of these circumstances has contributed to the existing inflationary problems. Additionally, the fact that the Central Bank of the Republic of Turkey (CBRT) missed consecutive inflation targets, has worsened the case by undermining the reliability and capability of the CBRT. Expected inflation and therefore the real inflation rates have spiraled out of control of the authorities, which have only increased the pressure on the lira. High inflation is exactly what Erdoğan believes to be the main cause of the underperformance of the economy, and he has publicly announced that he would be reducing interest rates after the presidential elections in Turkey in hopes of scaling down the inflation back to the targeted levels.

The Portfolio Balance Model, pioneered by Branson and Kouri in the late 70s, suggests that a contractionary sterilized foreign exchange operation could reduce interest rates just as it appreciates the home currency. Erdoğan’s promises seem to coincide with the ones of the model.

The graph below shows an interpretation of a contractionary foreign exchange operation (FXO) carried out simultaneously along with an expansionary open market operation (OMO). The combination of these two policies results in a sterilized foreign exchange operation (SFXO). President Erdoğan might be able to reduce interest rates by applying a similar SFXO.

Graphical representation of an SFXO on the Portfolio Balance Model.

In order to follow a contractionary FXO, authorities must sell foreign assets in exchange of domestic money, this in turn will increase the amount of agents’ holdings of foreign assets to finally shift the F-curve (foreign bonds) to the left from F1 to F2. Furthermore, the increase in the money base will be offset by a massive sale of domestic bonds, which will also result in a reduction of the supply of domestic bonds to finally yield a left shift of the B curve (domestic bonds). This shift is represented in the graph as a movement from B1 to B2. As can be seen, money supply remains constant in order to keep inflation stable.

President Erdoğan expects to win the next elections and to have a direct effect in the interest rates. However, it is my personal opinion that an SFXO will not work in the case of Turkey due to the absence of credibility of the CBRT. More than once has the CBRT promised lower inflation in order to have a direct effect on expected inflation, and more than once has the CBRT failed to meet such standards. Although Erdoğan winning the elections might bring “political stability” in the short-term and a probable reduction in country risk, the inflation rate will not be severely affected at least in the short term.

Furthermore, the constant promises of president Erdoğan regarding the Turkish economy create further speculation about the degree of independence of the CBRT, hence raising eyebrows about the future of the economy. If Erdoğan is indeed elected, Turkey will most likely be in risk of a potential massive capital outflow as many investors seek for opportunities in countries with a more credible central bank and a more credible president.


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