The Falling Lira

Since late 2021, the Turkish economy has been shattering conventional economic expectations. With deeply negative real interest rates, high inflation, a large and persistent current account deficit, an external debt stock exceeding 50 percent of GDP, and a central bank with net foreign exchange reserves estimated around -$50 billion, the economy has seemed permanently poised for crisis. 

Just this past year, Turkey’s Central Bank raised interest rates from a low of 8.5 percent in June to as high as 42.5 percent in December. The sudden increase represented a dramatic reversal of course from previous policy. Throughout much of 2022, negative real interest rates had generated a flight away from the Turkish lira, resulting in rapid depreciation of the currency. Given the high level of imported inputs in production, the loss in the value of the Turkish lira meant increased production costs, which were quickly passed onto prices. Inflation spiraled out of control and by August 2022 hit 80 percent.

Despite the central bank’s policy tightening, Turkish inflation is still running above 60 percent. This is at a time when the unemployment rate is close to 10 percent, with more than half of employed workers earning roughly the minimum wage—itself brought below the poverty line as inflation has rapidly eroded purchasing power. 

Behind the latest crisis, however, lie two decades of policy that have left Turkey with an increasingly narrow policy space, its economy depending on foreign capital inflows and imported inputs.¹ The result has been a mountain of fragilities, including a large and persistent current account deficit and a high external debt stock.

The IMF success story

During the late 1990s, Turkey suffered from increasing economic instability and persistently high inflation. The IMF-directed disinflation program implemented in 2000 prompted one of the most severe crises in the country’s history. In early 2001, sudden and rapid capital outflows led to a currency crisis, which quickly turned into a banking and financial crisis. In response, the IMF imposed strict austerity measures, including high interest rates, primary budget surpluses, and a slew of privatizations. This coincided with increasing global liquidity and declining interest rates worldwide, which meant that international finance saw its opportunity in Turkey’s newly introduced higher rates. With the IMF’s imposed privatizations, international investors snapped up cheap acquisitions. Coming to power in 2002, Erdoğan followed the IMF program to the letter and foreign capital began flowing in; by 2006, the ratio of foreign capital inflows to GDP reached 11.3 percent, a historical record.

The 2008 financial crisis did little to disrupt the pattern. Though capital markets momentarily dried up, quantitative easing in the US, Europe, and Japan eased global liquidity conditions. Once more, Turkey attracted large capital inflows, mostly in portfolio investment and private foreign debt. From 2010 onwards, economic growth continued, with wide current account deficits and increasing private sector external debt. 

Cracks in the model

It wasn’t until the Fed’s switch to quantitative tightening in the mid-2010s that the underlying fragilities in the Turkish economy were revealed. Turkey was classified among the so-called “fragile five” by Morgan Stanley, together with Indonesia, Brazil, India, and South Africa—all with large current account deficits and high external debt levels. To deal with the deficits, capital inflows would be needed, which would in turn require higher interest rates. Higher interest rates would mean slowed economic growth; keeping them fixed, on the other hand, would generate depreciation pressures on the Turkish lira. Turkey was faced with a classic dilemma: raise the interest rate to keep the exchange rate stable but tolerate slower growth—maybe even a recession—or keep the interest rates low but tolerate the currency’s depreciation—maybe even a currency crisis.

A series of elections from 2015 to 2019 compounded the crisis: with rising political instability, Erdoğan’s governments prioritized economic growth over long-term economic strength. For example, in 2017, it used its Credit Guarantee Fund, a facility initially designed to support small and medium enterprises, to support credit expansion. With economic growth, however, came large current account deficits. Once capital inflows slowed, depreciation pressures on the Turkish lira increased. The tower came tumbling down in 2018, with a currency crisis followed by interest rate hikes and a recession.  

It was evident that the good old days of high economic growth, low inflation, low interest rates, and low exchange rates were over; they had always depended on massive foreign capital inflows. But in the aftermath of the pandemic, the global economic environment had changed. Not only have the global conditions that supported these inflows changed, but the fragilities that these inflows generated over time were now threatening growth and stability. In 2020, another round of interest rate cuts, this time to support the economy during the pandemic, would bring the country to the brink of a balance of payments crisis in the fall of 2020 as capital outflows continued. It also turned out that the central bank had used most of its foreign currency reserves to stabilize the exchange rates while keeping interest rates low. In fall 2020, another round of interest rate increases began stabilizing the foreign exchange markets. 

Interest rate experiment

As structural weaknesses rose to the surface, high interest rates could no longer attract adequate amounts of foreign capital. In 2021, domestic firms struggled as export markets demanded further currency depreciation. 

Just as global interest rates began their upward climb, Erdoğan initiated his low-interest rate experiment. Key to this was Erdoğan’s decision to replace the finance minister and the governor of the central bank overnight with non-orthodox figures who supported lower rates. 

The government argued that lower interest rates would boost productive investment and that currency depreciation would trigger import substitution, thus ridding Turkey of its chronic current account deficits. In fact, currency depreciation quickly spiraled out of control. When the new round of interest rate cuts began in the fall of 2021, an accelerating flight away from the Turkish lira and lira-denominated assets emerged, sending the currency into freefall.

This resulted in an increased demand for foreign currency. With Turkey’s high dependence on imports, the depreciation increased domestic price levels and inflation skyrocketed. Some depreciation had been desired, but the government had not expected the free fall that eventuated. When people began rapidly selling their Turkish lira denominated assets to buy foreign currency, the government introduced “exchange rate protected deposit accounts” in a bid to tame the demand for foreign currency by guaranteeing domestic residents a return equal to the rate of depreciation in domestic currency. These accounts denominated in Turkish lira carried the promise of the government and the central bank that if the depreciation rate were to exceed the interest rate, the account holders would be compensated for the difference by the central bank or the Treasury. This was supported through indirect central bank interventions that aimed to manage a more orderly depreciation of the currency. The government and the central bank used borrowed foreign exchange reserves to meet this demand, while introducing “exchange rate protected deposit accounts” for domestic residents to prevent further dollarization of savings. The use of borrowed reserves to intervene in the currency market by the central bank resulted in negative net reserves and made it increasingly difficult to carry on the low interest rate policy. 

The rapid rise of inflation sent the real interest rates plummeting to record lows. While “exchange rate protected deposit accounts” successfully curtailed domestic residents’ foreign currency demand, capital controls on lira-foreign currency swaps between domestic banks and the London market, first implemented in the aftermath of the 2018 currency crisis, prevented currency speculation. Yet, widening current account deficits in 2022 made this policy course increasingly challenging to sustain. In the absence of sufficient foreign capital inflows, the central bank was using borrowed reserves (both from domestic banks and foreign central banks) to prevent another currency shock. With presidential elections scheduled for 2023, the government had been unwilling to give up the expansionary impact of negative real interest rates—only to change course once the elections were won. 

As high inflation persisted, wage increases lagged and, in most cases, did not compensate for declining real wages. All the while, firms adjusted their prices and even increased profits. High inflation and low interest rates not only allowed the firms an opportunity for debt-financed investment but also resulted in debt-financed speculation, especially in real estate. The result was an unprecedented decline in the labor share of income.

Austerity loading

While the government may have had some success in maintaining growth in the economy whilst keeping employment levels relatively high, the tumbling value of the Turkish lira plus high inflation rates have meant immiseration for many. 

Broader lessons can be gleaned from the Turkish case, particularly with regard to the limited policy space available for developing and emerging economies that are highly integrated to the global economy through open trade and financial flows: namely, having an independent monetary policy is not possible without capital controls. This brief period of expansionary monetary policy was only feasible thanks to selective capital controls (preventing swap agreements between domestic banks and London to minimize currency speculation), heavy central bank interventions in the foreign exchange market, and new financial products such as “exchange rate protected deposit accounts” curbing domestic residents’ demand for foreign currency. 

Even then, this experiment ground to a halt in June 2023 when Erdoğan opted to appoint a new finance minister and a new central bank governor to appease the powerhouses of international finance capital. It is now becoming increasingly apparent that, once again, the burden of adjustment will be put on labor as wage increases lag behind inflation and high interest rates and austerity policies are likely to increase unemployment.