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Turkey's Tricky Path Forward

In late March, Turkey’s President Recep Tayyip Erdogan fired the country’s central bank head Naci Agbal, along with his deputy 10 days later, making Agbal the third fired central bank leader in less than two years and curtailing his tenure at roughly four months. A former member of Parliament (and fellow member of Erdogan’s Justice and Development party), Sahap Kavcioglu, will assume the (historically perilously short-lived) role. 

Erdogan’s decision comes as investors had seemingly shown some approval of Agbal’s early policy approach—including a whopping 8.75pp hike in the benchmark interest rate to 19% in an attempt to fend off inflation, which had reached north of 15%, and keep capital from fleeing. Compounding Turkey’s challenge has been a weak lira, which makes servicing its sizeable external debt challenging.  

Erdogan is a known opponent of high interest rates—which he views as usury—and it’s worth noting that Kavcioglu, who wrote op-eds for Turkey’s pro-government newspaper before his appointment, has expressed his agreement with Erdogan’s opposition. Then, too, there’s some speculation Erdogan’s party might call for early elections later this year—a move possibly aimed at catching the opposition off-guard and capitalizing on relatively robust growth coming out of a challenging 2020. Though to be fair, much of that growth was likely spurred by state banks’ near-doubling in lending, which in turn contributed to inflation and a deteriorating currency as too many lira chased too few goods. By March 2020, the spread between the lira and the US dollar had reached all-time highs—and it only continued climbing until Agbal raised rates in November and seemingly signaled a return to more orthodox monetary policy. Almost immediately, the lira strengthened. Since replacing Agbal, most of those gains have reversed.  

This challenging domestic environment exists against a potentially even more challenging global backdrop as Turkey’s external debt has mounted over the last decade. Amid a record-low US interest rate environment, Turkey borrowed heavily in US dollars—in academic economic jargon, committing original sin—with much of that debt set to mature in the near term, even as the lira weakens and makes repayment more challenging. Some estimate Turkish banks owe $89bn in external loans over the next 12 months—some 12.5% of Turkey’s GDP. Foreign currency loans account for 44% of banks’ corporate loans. Further compounding weakening lira concerns, Turkey’s central bank has borrowed heavily from domestic banks in dollars—it had a $25bn shortfall by mid-2020. If the dollar strengthens, the central bank may also struggle to repay.

Turkey’s far from the only emerging markets country to borrow in dollars—Russia, Iran, India and others have also. But it leaves Turkey’s central bank precariously positioned and flirting with the age-old trilemma of balancing control over exchange rates, capital flows and monetary policy. To be fair, the lira floats—it doesn’t have a fixed exchange to the dollar or any other currency—but the country clearly has an interest in maintaining its exchange rate. In fact, the opposition party alleges the government spent some $128bn in foreign exchange reserves defending the currency over the last two years. And Erdogan seems determined to control monetary policy and maintain low interest rates. Which would point to the possibility the country will need to institute capital controls if it wants to achieve those other two ends—though the finance minister has indicated the administration has ruled them out, and the ruling party does tend to be pretty business-friendly. But given all this is occurring against a backdrop of rising US rates, Erdogan may find himself with fewer options.  

Regardless of the way forward, Erdogan seems determined to continue serving as de facto head of the central bank—potentially putting at risk the country’s ability to reasonably navigate an admittedly tricky path forward.