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How controversial monetary policy is causing high inflation in Turkey

🕑 4 min By Mariusz Rzepa


1. Background


In 2020, the coronavirus has significantly impacted the Turkish economy, namely the biggest two industries of Turkey, namely manufacturing, and tourism. Those two industries have been suspended from action for the last two years due to the pandemic. To survive, the companies had to run into debt mostly in foreign entities. To service those loans, they took out billions of liras from circulation. This had an impact on the domestic currency, as it accelerated its depreciation.


The central bank of Turkey in November 2020 initially increased the interest rates, which is a textbook response to the currency devaluation, however, Turkish president Erdogan quickly ceased those actions. He has ordered the CB to lower the interest rates and has fired part of the chairmen of the Central Bank, who refused to do so. Erdogan is convinced, that currency depreciation is a good phenomenon, as it makes Turkish exports more competitive in the worldwide exchange market. Inspired by the economic movements of China, which purposefully depreciates its currency, the Turkish president has to impose the same narration (Cheng, 2021).


The problem is that the Chinese economy is far more self-reliant compared to the Turkish economy. This can be seen when looking at imports of food, fuel, or fertilizer, which are absolute necessities for many capital industries in the country. What happens now is that many entrepreneurships and small businesses cannot afford to import goods, and simply must shut down. At the same time, the wealthy Turks moved all their savings into American dollars to foreign savings accounts, which further accelerated the domestic currency depreciation. This phenomenon is currently so common in turkey, that it even got a name- “the dollarization problem”. Now Turkish inflation exceeded 80% for the first time since September 1998, achieving the record rate of 80.2% in August. The median forecast of economists surveyed by Bloomberg depicts an even more radical score by the end of this year (Akman, 2022).


2. Why isn't Turkey just increasing their interest rates?

There are 4 main reasons to explain the inactivity of the Turkish government regarding the interest rate:

1. Political motivation


Erdogan is a strong believer in Islam, and therefore, based on this religion, Islamic finance. Qur'an, the central religious text of Islam, strictly prohibits “riba”, usury, or interest. Following that interest rates should not have any bearing on the economy of a country affiliated with this religion (Seho, 2020).

2. Admitting their mistake


Raising an interest rate after years of contrary political approach would be recognized as admitting their mistake, or in other words, that the Turkish economy was wrongly managed for the past years. The president does not want to be seen that way, as it may hurt the public’s trust in him and, effectively, his election results.


3. Contrary belief


According to a few specialists, a decrease in the interest rate may be an unnecessary practice for this specific economy. Turak (2022) states, that Turkey has a very solid foundation to tackle the inflation problem without any governmental interventionism, these points are a young, skilled workforce and an economy that is decentralized among various industries. Many politicians supporting president Erdogan promote this perspective and keep him confident regarding the correctness of his previous economic decisions.


4. The new type of savings account


To fight the aforementioned dollarization problem, the Turkish government has announced to introduce of a new savings account type, which is planned to protect borrowers from inflation. The account is intended to work as follows: any money deposited in the account will grow with the given annual interest rate, additionally, at the end of the fixed borrowing period, the Turkish treasury will pay out the extra amount equal to the value lost due to inflation, and therefore currency depreciation.



For example, assuming that the investor deposits 1000 lira into the yearly deposit account, the yearly interest rate is 10%, and due to the enormous inflation, the currency has depreciated from the rate of 10 lira per 1$ to 20 lira per 1$, the process on the expiry date works as follows. The investor gets his 1000 lira back with the interest of 100, plus as the currency depreciated, the treasury bank will award him with an additional 1000 lira, as a form of compensation, effectively summing all into 2100 lira.


This idea seems like a desperate way to retain investors to deposit their funds in the sovereign market, however, may work and even may encourage many Turks to transfer their savings from the US accounts back into their homeland. Many critics however raise awareness of the risk that comes with this new Turkish invention. The governmental assumption while publishing the news was that the depreciation of the lira would effectively decrease. What will happen if this assumption is wrong? The treasury bank would be significantly indebted as the compensational awards will skyrocket. The government would be forced to either default on the compensation promise, or directly borrow the money from the Turkish Central Bank. Any result of those activities will either revoke the public scandal or expose the government to a significant liability, which may push Turkey towards the fate of Venezuela.


3. Closing thoughts


As can be seen, the Turkish economy for the past few years is severely struggling, and the stubbornness toward a fixed monetary policy may have even stronger consequences. Erdogan sticking to his original principles shows that against all critics, he has his own plan for Turkey. This will lead to very uncertain times for its economy.


Written by Mariusz Rzepa

September 2022



References:


Akman B. (2022, Sep), Turkey’s Inflation Exceeds 80% in Worst Price Blowout Since 1998,


Cheng E. (2021, Jun), China rushes to pull back the yuan from a three-year high, https://www.cnbc.com/2021/06/03/china-sets-yuan-rmb-weaker-vs-us-dollar-for-first-time-in-a-week.html


FRED (2022, Sep), Interest Rates, Discount Rate for Turkey


Seho M. (2020, Sep), The effects of interest rate on Islamic bank financing instruments: Cross-country evidence from dual-banking system, https://www-sciencedirect-com.mu.idm.oclc.org/science/article/pii/S0927538X19307164#:~:text=For%20most%20Islamic%20finance%20academicians,'an%202%3A275


Trading Economics (2022, Sep), Turkey Inflation Rate, https://tradingeconomics.com/turkey/inflation-cpi


Turak N. (2022, Jun), Turkey’s inflation soars to 73%, a 23-year high, as food and energy costs skyrocket, https://www.cnbc.com/2022/06/03/turkeys-inflation-soars-to-73percent-as-food-and-energy-costs-skyrocket.html



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