Turkish President Recep Erdogan’s pride in his country’s recent interest rate cut calls to mind the apocryphal story of the mother’s pride in her son at a military parade. The source of her pride was that her son was the only one in the parade who, in her mind at least, was marching in step.
Erdogan similarly takes pride in his country’s central bank cutting interest rates at a time of rising domestic inflation. He does so even when most of the world’s central banks, including those in the emerging markets, are in the process of tightening their monetary policies in response to signs of rising inflation.
Over the past year, Erdogan has fired three central bank governors for not complying with his eccentric view that high interest rates are the cause of inflation, rather than a cure. Last week, Sahap Kavcioglu, Turkey’s most recent central bank governor, seemed to yield to Erdogan’s demands by cutting interest rates by 100 basis points from 18 percent to 17 percent. He did so even at a time that inflation had accelerated to 19 percent. He also did so at a time that the Turkish lira was the world’s worst performing currency, as underlined by a 16 percent drop in the currency since the start of the year.
Even more surprising about Turkey’s sharp reduction in interest rates was that it flew in the face of the International Monetary Fund’s (IMF) explicit warning about the dangers of such a move.
In a recent report, the IMF observed that even before COVID-19 the Turkish economy suffered from external vulnerabilities in the form of uncomfortably low international reserves, a large amount of banking system dollar deposits and a high amount of dollar-denominated corporate debt. Those vulnerabilities have increased as a result of the very strong monetary policy response to the COVID-19 crisis. This was underlined by a re-emergence of a significant external current account deficit and a rise in dollar denominated deposits to as much as 60 percent of the banking system’s overall deposits.
Despite the country’s shaky banking system, its low level of international reserves and its uncomfortably high amount of dollar-denominated corporate debt, it has managed to avoid a full-fledged currency crisis. It has done so as its banks have continued to have easy access to a global capital market that was awash with liquidity and that had international investors desperate for yield in a low world interest rate environment.
Making Erdogan’s gamble all the more reckless is the strong likelihood that we are moving towards a less benign international liquidity environment. In response to incipient signs of inflation across many countries, many central banks have already started tightening policy. Meanwhile, Federal Reserve Chairman Jerome Powell is giving increased signs that the Federal Reserve is about to start tapering its aggressive bond buying program, which he has suggested is likely to end by mid-2022. This runs the risk of putting Turkey once again in the front line of those emerging market economies that will be severely impacted by a shift to tightening world monetary policy conditions, as occurred during the 2013 Bernanke Taper Tantrum.
None of this bodes well for the Turkish economy in the run-up to its presidential elections in 2023. Domestic and foreign investors will likely head for the door as they see interest rates lagging behind inflation and as interest rates abroad become more attractive. That in turn is likely to send the currency to yet lower levels, which will feed the upward march in domestic inflation for which Erdogan could pay a heavy price in the 2023 election.
A silver lining is that Turkey’s economic troubles may serve as a cautionary tale for other emerging market economies about the dangers of pursuing unorthodox monetary policies at a time of tightening global liquidity conditions. It might also serve as an early warning to policymakers in the advanced industrial countries of potential trouble ahead in the emerging market economies.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.