Economic experience or suicide? “Balık baştan kokar” (A fish rots from… | by Sagar Singh Setia | June 2022

Balık baştan kokar” (A fish rots from the head down / Corruption begins at the top) – famous turkish proverb

Source: Photo by beytlik

Netflix’s historic docudrama »Rise of Empires: Ottomans » beautifully depicts the conquest of Constantinople by Mehmed the Conqueror. The The Romans ruled the “strategic” Constantinople (today’s Istanbul) for centuries before falling into the hands of the Ottomans. With the center of power in Istanbul, the mighty Ottomans ruled over large swaths of Europe, the Middle East and even Africa. However, the Sultanate’s rule over the Ottoman Empire ended after 623 years on November 1, 1922, and so 100 years ago we had modern day Turkey.

You may be wondering why a little history lesson today? Well, that’s because we have to understand that the Ottoman Empire was one of the most powerful empires in medieval history, and Turkey’s strategic location makes it vulnerable to geopolitical conflict. Surrounded by Syria, Iran, Georgia and Greece, Turkey’s geography means that conflicts and controversies always trouble it.

Let’s dive deep into Turkey’s economic problems and how the current president’s experience could lead Turkey to “Hyperinflation”. We will discuss the following:

  • A brief history of Turkey’s economic problems in the 80s and 90s.
  • The factors that led to today’s episode.
  • The “economic experience”
  • Conclusion

Turkey has long had an import substitution policy where domestic manufacturers and goods were encouraged over foreign goods. However, in the early 1980s, Turkey witnessed the Balance of Payments (BOP) crisis which led to a deep economic recession and social and political chaos. Inflation hit 120% in 1980 and a military regime worked hard to bring inflation down to 28% over the next three years.

Source: Marquee Finance by Sagar

The Turkish lira was devalued, the exchange rate system changed from a fixed exchange rate system to a “managed” floating system, and numerous free market reforms were introduced to sort out the economic mess. Unfortunately, the structural reforms never worked and Turkey faced another episode of high inflation in 1994, similar to that of the late 1970s and which led to a “currency crisis”. The lira, which was 0.0017 in USD in 1988, fell to 0.04 in 1995!!

Source: Marquee Finance by Sagar

So even after the structural reforms, what was wrong? Again, the devil is in the details:

Public spending exploded massively in the run-up to successive elections. Taxes have not caught up with spending and thus the public deficit has reached astronomical levels. The high public deficit was “funded/monetized” by none other than the Turkish Central Bank. The interest payments which were only 4% in public spending in 1981, reached more than 20% by the end of the 1980s. The promises of successive governments to reduce spending have failed.

PS: The 1980s saw the PKK (Kurdistan Workers’ Party) wage a guerrilla war against Turkey in the east of the country. If political instability was the fire in the 1980s, then the conflict in the East was the fuel.

The government has failed miserably to stem the economic mess. Even after the liberalization of current and capital accounts in the 1980s, the Central Bank (which was not independent and was run by the Turkish federal government) and the government could not control “constantly high” inflation and avoid an economic crisis.

Macro learning:

A high “fiscal deficit” bodes ill for the economy; this puts pressure on the currency as the country’s currency depreciates! Why? Because to finance the high budget deficit, the government borrows on the market. Therefore, if there are not enough savings in the economy, the Central Bank has to finance the deficit by printing the local currency, thus causing the local currency to depreciate.

Fast forward to 2014, and Turkey has a new president: Recep Tayyip Erdoğan”. Erdoğan’s authoritarian rule was marred by massive corruption scandals, a failed coup, mainstream media censorship and economic disaster. But how did Turkey come to this situation? Understand!

As always happens in an economic crisis, the high indebtedness of the Turkish corporate sector triggered the economic problems in Turkey. The Turkish private sector has resorted to a credit binge from foreign banks and institutions, especially countries like Germany and other European banks. The huge foreign debt was comfortable until things got rosy with the West; however, the problem started when Turkey was denied full-time NATO membership due to “human rights concerns”. As a result, European banks have been wary of lending to Turkish companies. As if that were not enough, Erdoğan defied the Trump administration by buying oil from Iran despite sanctions, buying S-400 missile systems from Russia and launder Iranian oil revenues into physical gold via Turkish banks!

This all happened in 2018, and slowly and steadily the US and EU raged in an economic war against Turkey. Turkey’s proximity to Russia and China has further dampened the West’s response, and the first and most important attack was on Lira. The rest is history:

Turkey entered a negative loop, where the economic crisis was responded to by a credit stimulus which led to the widening of the current account deficit, which led to a decline in the lira. The fall of the lira has led to increased inflation as Turkey imports most of its energy needs. This has been a continuous phenomenon since 2018.

Erdoğan refused the call for help from the IMF in 2019 and took control of the Turkish Central Bank (yes, it is no longer independent). Turkey has tried to reduce its dependence on external debt. However, the post-pandemic tsunami of cash hampered the process. And when the Fed started to close the doors of liquidity, as expected, Lira was faced with reality again and inflation exploded!

For the West, the biggest economic experiment to date has been QE, in my honest opinion. However, for Turkey, Erdoğan, a strong supporter of Islamic finance, did the opposite of what conventional economics advocates.

Over the past three years, Turkey’s monetary policy has been the opposite of what all other central banks have done. When the Fed was doing QT1: Turkey was relaxing; when the Fed was easing: Turkey was tightening, and now that the Fed is doing QT2, Turkey is following an accommodative monetary policy again.

Why is Turkey’s monetary policy the greatest economic experiment of all time?

Conventional economy: When inflation is high and the currency depreciates; macroeconomics teaches us that interest rates should be increased so that a) foreign capital enters your country/outflow from the local forex market stops and the currency stabilizes and b) inflation goes down because high interest rates lead to lower demand.

Erdoğan experience: With the lira depreciating from 7 to 17 in just two years and a CPI of 73.5%, any central bank in the world would have raised interest rates to control the economic catastrophe. However, Turkey’s central bank, on Erdoğan’s orders, cut interest rates, which have now been reduced to 14.75% from 19% and Erdoğan has pledged to cut the key rate further.

Source: Marquee Finance by Sagar

Erdoğan is confident in his actions and believes Turkey will emerge from the economic mess and inflation will decline in the future as the country moves into a current account surplus next year. However, conventional economics teaches us that Turkey’s path will lead to one and only one place: “Hyperinflation”.

Erdoğan tries to de-dollarize the Turkish economy with his reckless actions. The Turks lost faith in the Turkish government and therefore moved their savings from lira to foreign currencies, potentially to USD and EUR.

This further exacerbated Erdoğan’s problems and to reassure his citizens, Erdoğan promised to compensate holders of lira deposits if the value of the currency depreciated by more than the interest rate offered by banks on those deposits. .

As Russia continues its fight with the West, it has the currency of raw materials, fertilizers and food. However, Turkey does not have the strength to challenge the West even though it has the full support of Russia and China.

Only time will tell if Erdoğan succeeds in his experiment. We must be aware that Erdoğan is playing a dangerous game with the West. Turkey is in a decisive situation with Erdoğan at the helm. Before I finish, you should read this table carefully; Turkey net foreign assets (including swaps) are now in negative territory (which means they have no more firepower to defend the Lira). Yet we have an inflexible head of state!

As I finish writing, Turkey’s CDS (Credit Default Swaps) hit a 14-year high of 9%/900 bps! With a sovereign default in sight, a plummeting currency, negative net foreign exchange reserves and spiraling inflationTurkey is undoubtedly heading for economic disaster, and only a miracle can now save its economy!

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