Turkey’s Central Bank has seen its credibility wane both at home and abroad after coming under full government control as a result of a series of moves by President Recep Tayyip Erdogan in the past two years. The bank could hardly be described as autonomous, independent or even relatively independent any longer. Erdogan himself makes no secret of the bank’s descent into obedience, asserting publicly that its former governor was sacked because he refused to heed his demands.
The Central Bank management is now doing what the government wants — not only in terms of monetary policy, but also by intervening in the foreign exchange market, something it is supposed to never do.
The bank’s overt submission, however, is taking a toll on the much-needed flow of foreign capital to the country. Even investors eyeing short-term speculative profits have grown reluctant to put money in Turkey, facing an unpredictable Central Bank that is flouting market norms and using back-channel methods to manipulate hard currency prices. And many who have already invested in Turkey are looking for the right moment to flee.
Still, the government is failing to realize — or prefers not to acknowledge — that this state of affairs is weakening further the external tailwinds that the Turkish economy needs to extricate itself from the current crisis.
The 2001 economic crisis, arguably the worst Turkey has ever experienced, was overcome through a series of stiff measures prescribed by the International Monetary Fund that took a heavy toll on the populace. The measures included a legal amendment that clearly defined fighting inflation as the primary task of the Central Bank and entitled it to independence in choosing the tools it would employ for that purpose.
The Central Bank did its job more or less without problems after Erdogan’s Justice and Development Party (AKP) came to power in November 2002, but government pressure mounted in time. Ultimately, the bank faced Erdogan’s wrath as Turkey plunged into crisis in 2018 and the AKP suffered big losses in the local elections earlier this year.
Consumer inflation shot up to more than 20% in 2018, fueled by a severe currency shock in the second half of the year and supply shortages in food products as a result of a decline in the agricultural sector. Low-income groups were hit the worst by the soaring inflation, marked by increases of more than 30% in food prices.
The solution Erdogan proposed to rein in inflation was to pull down interest rates.
Erdogan, a practicing Muslim known to be averse to interest on Islamic grounds, has come up also with an unorthodox economic theory that high interest rates fuel inflation. “When we look at the cause and effect relationship, interest rates are the cause and inflation is the result. The lower the interest rates, the lower the inflation,” he argued in a memorable interview with Bloomberg in London in May 2018, just weeks before crucial elections that would mark Turkey’s transition to a new governance system bestowing sweeping powers to the president.
At an AKP management meeting the month before, Erdogan had fumed at the Central Bank for defying his instructions and hiking rates while he was on a trip overseas. “Before I went abroad, we had a meeting on interest rates and we talked about lowering them. Then, the Central Bank raised the rates while I was abroad. They did it behind my back,” he was quoted as saying.
In London, Erdogan not only insisted on his peculiar economic views but also vowed to tighten his grip over the Central Bank once the new executive presidency took effect, fueling concern among international investors. This led to a tangible flight of foreign capital from Turkey, and the Turkish lira tumbled against the dollar.
After Erdogan’s victory in the June 24 elections that year, foreign investors tended to wait and see how he would sway monetary policies. In the meantime, however, political tensions with Washington escalated over Turkey’s detention of an American pastor, with President Donald Trump threatening Ankara and eventually slapping sanctions on two top Turkish officials. The row sent the Turkish lira nosediving to record lows. To stop the tailspin, the Central Bank raised its policy rate by a staggering 625 base points.
By autumn 2018, the economy became even more difficult to manage. Amid the soaring inflation, the economic downturn was devolving into a recession. The construction sector, which is dominated by government cronies, was among the worst hit as sales plunged and the housing stock grew. To revive the sales and relieve the sector, interest rates had to go down. Erdogan turned up the pressure on the Central Bank and ultimately fired its governor in July. Other senior managers were sacked shortly afterward. Since the appointment of the new, docile governor, the Central Bank has thrice cut interest rates, delivering what the president wanted.
On Nov. 5, a visibly pleased Erdogan said, “We dismissed the previous Central Bank governor because he did not listen to what we said. We moved forward with the new one, saying we would lower interest rates because interest rates are the greatest cruelty against the development of a country. Look, we have now brought inflation down to single digits and relatively stabilized foreign exchange rates.”
Yet the facts on the ground do not corroborate Erdogan’s claim that inflation has fallen because of the lowered interest rates. Inflation did ease to 9.2% in September and 8.5% in October, but this had to do with the base effect — that is, the huge price increases in the same periods last year. As this base effect dissipates in November and December, consumer inflation is likely to climb back to the region of 12% to 15%. This would leave no room for further rate cuts and, moreover, create pressure to hike them anew. Given the treasury’s tight domestic debt repayment calendar, the rates would have to go up to have the banks finance the treasury.
When it comes to hard currency prices, the Central Bank has neither the task nor the authority to intervene in foreign exchange markets. Yet as Erdogan publicly acknowledged, it has stepped into this as well. The bank has come to sell hard currency through “the back door” — swaying foreign-exchange prices and shaking confidence at the markets. Investors expect foreign exchange prices to be determined by the market, but the Central Bank has been intervening via state banks, using its reserves. Such maneuvers from outside are raising worries among investors and discouraging them from the market.
Obviously, the inflow of foreign capital is slowing down too, as international investors lose confidence in the Turkish market and Ankara’s credibility wanes. Ultimately, this threatens to prolong the crisis gripping the Turkish economy, for credibility and trust are the most precious coin of the realm in times of turmoil.