Despite Recent Growth, Turkey’s Economy Remains Fragile

The economic growth Turkey’s seen this year is unlikely to be sustainable in the long term, as President Recep Tayyip Erdogan pushes to cut interest rates in ways that further destabilize the country’s already fragile currency and financial situation. Erdogan has been clear in recent statements that he wants to begin easing Turkey’s high-interest rates despite ongoing high inflation in the country, which doesn’t bode well to begin an easing cycle. Currency, balance of payments and debt crises are not imminent, but capital flight and tighter financial market conditions will accelerate trends in that direction. 

• Erdogan is well known for his unorthodox monetary policy, which embraces easing at all costs to promote economic growth and, in his view, help tame high inflation.
• This unorthodox approach has spurred numerous personnel shake-ups at the helm of Turkey’s central bank in recent years, prompting currency outflows by damaging confidence in the bank’s political independence. 

A recent small dip in inflation will add fuel to Erdogan’s push to cut interest rates before the central bank is ready to embrace easing. May's inflation numbers show the first slowdown in seven months, halting the record rise for now but still leaving Turkey with some of the highest inflation rates in the world. Annual consumer price index (CPI) inflation went down to 16.6% last month from 17.1% in April. Despite remaining well above Turkey’s official inflation target of 5%, the recent dip — even if temporary — will fuel Erdogan’s calls for lower interest rates, making an interest rate cut more likely in the coming months. The governor of Turkey’s central bank, Sahap Kavcioglu, followed Erdogan’s latest calls for easing with the assertion that “expectations for an early easing of policy...need to disappear.”

• Core inflation in Turkey also dropped from just above 17% in April to 17.0% in May. Goods inflation at 17.9% is down from its highest level since mid-2019 a month ago. Prices of services, however, continue to tick up.
• It is possible that the May inflation data drop is skewed by the end-of-Ramadan lockdown that the Turkish government imposed in May, making it too early to tell whether the inflation tides have turned in Turkey. 

Turkey’s recent economic growth is probably not sustainable, as the lira continues to weaken due to a lack of investor confidence in the country’s currency and government. According to official government data TurkStat released on May 31, Turkey’s economy grew faster than all other Group of 20 (G-20) nations apart from China in the first quarter of 2021, with its GDP expanding by 7%. But this swift growth was fueled by government stimulus and lending that will ultimately only add to the country’s debt woes. The recent expansion is also happening as purchasing power has weakened amid the lira’s sliding exchange rate, making such growth all the more unsustainable in the long term. 

• Household consumption in Turkey jumped 7.4% during the first quarter of the year compared with a year earlier, and manufacturing increased substantially, which TurkStat says are the main drivers of growth. But significant government spending and boosts in lending, as well as a weaker currency, are also supporting those factors. Turkish banks were encouraged to grant loans to businesses and consumers throughout 2020, especially the latter half, in order to keep growth high. 
• Erdogan’s rhetoric continues to put pressure on the lira exchange rate, as well as dampen investor sentiment, leading to capital flight. Following Erdogan’s June 1 statement about an interest rate cut being “imperative,” the Turkish currency hit new lows. The recent lira declines were also exacerbated by Turkish companies being forced to roll over $6.9 billion in foreign currency loans in June.

Turkey’s grim long-term economic outlook could ultimately threaten Erdogan and his ruling Justice and Development Party (AKP)’s grasp on power. Pressure from Erdogan for interest rate cuts in the face of high inflation could further weaken the exchange rate and spur other negative political and economic implications. 

• Fragile growth will give political opposition another talking point against the AKP’s economic strategy, as opposition papers and politicians attack the numbers as overly optimistic and not reflective of Turkey’s starker economic reality. Although 2023 elections are still two years away, the AKP’s polling numbers have recently hit record lows, due mainly to the country’s deteriorating economic situation.
• Foreign investor sentiment risks souring further, which will further detract from foreign currency inflows — especially if rating agencies further downgrade Turkey’s credit (which, according to a recent Reuters report, S&P Global Ratings is considering doing). 
• Dollarization is likely to continue as the exchange rate weakens, detracting from Erdogan’s constant rhetoric push to ramp up domestic investment and trust in the lira.
• Swift easing risks exacerbating Turkey’s balance of payments crisis, which has already been steadily worsening over the last year, as the government swiftly drains its net foreign currency reserves. Between 2019 and 2020, the Turkish government sold off $128 billion in reserves to stabilize the lira.