Erdogan’s new economic mechanism: How it works, how it affects inflation

Turkey’s emergency measures to boost the pound’s stability are in fact a covert rise in interest rates, leaving the state budget more vulnerable to future currency crises.

The Turkish currency has lost more than 50 percent of its value against the dollar since September as President Recep Tayyip Erdogan relied on the Central Bank of Turkey (TCMB) to cut borrowing costs in a bid to attract investment and its declining popularity. A bailout announced Monday night promised investors protection against unimaginable currency fluctuations and sent the pound soaring (+ 20%), which could provide Erdogan with time politically in the run-up to the 2023 elections.

Should the pound fall against hard currencies exceeding bank interest rates, the government will pay depositors the difference in pounds. But by putting a threshold below the pound in this way, the government has raised interest rates without saying so, while depriving pound holders of the benefits, critics say.

“There has been an epic rise in interest rates without calling it that,” said Refet Gurkainak, a professor of economics at Bilkent University in Ankara, who spoke to Bloomberg. “There will be a big burden on the budget when there is a sharp rise in the exchange rate. This kind of charge is usually converted into money, which means even higher exchange rates and inflation.”

Sacrificing the budget

The plan is to curb private investor demand for dollars, but bypassing a formal interest rate hike comes at a cost: The Treasury will now take losses on new pound deposits in the event of a re-sale of the currency.

This places one of the few remaining bright spots in the Turkish economy – its fiscal position – and underscores a growing tendency among policymakers to rely on the public budget to pay for the costs of wrong policies.

“We can say that the budget – the last remaining element – was sacrificed so that we can say that interest rate hikes were avoided,” said Ibrahim Turhan, a former deputy governor of the Turkish Central Bank who is now an opposition politician. “In this way, the cost of the devaluation of the pound is borne by society as a whole.”

The pound rose more than 20 percent after Erdogan’s speech before cutting some of those gains on Tuesday, when it traded down 5 percent to $ 14.0366 at 11:30 a.m. to Constantinople. Even so, the currency is still below 30% against the dollar this year. This and the sharp rise in the minimum wage announced last week will continue to fuel annual inflation beyond 21.3% last month, compared to the government target of 5% and the central bank’s reference rate at 14%.

The measures seal weeks of central bank interventions in foreign exchange markets, which have failed to stabilize markets despite the billions of dollars Turkey has sold from its foreign exchange reserves.

Erdogan’s new mechanism

1. How does the new mechanism work?

The Treasury Department will make up for losses suffered by pound holders if the pound’s fall against hard currencies exceeds bank interest rates. For example, if banks pay 15% on one-year pound deposits but the pound depreciates by 20% against the dollar over the same period, the Treasury – that is, taxpayers – will pay the difference to depositors. Only new retail accounts will be able to benefit from the program, according to the head of the Turkish Banking Association, Alpaslan Cakar, and there is likely to be a minimum payment deadline.

2. How will it help the pound appreciate?

If people who hold hard currency deposits decide to switch to the pound, this could help the Turkish currency reduce its losses. More than half of deposits in the Turkish banking system are in hard currencies, according to banking supervision. However, because the average duration of foreign currency accounts is only several weeks, they are unlikely to be converted en masse into new deposits in pounds.

3. What does it mean for inflation and public finances?

Potentially, the Treasury Department assumes a foreign exchange risk of 3, 3.3 trillion ($ 265 billion) currently deposited in retail bank accounts. If the pound depreciated at a higher rate than deposit rates, this would burden the budget. If the Central Bank prints money to cover the difference, then inflation would skyrocket.

4. Does this plan address the substance of the problem?

While the worst may be over for the pound at the moment, restoring some confidence in retail depositors, “until interest rates provide a credible anchor against inflation, the pound will tend to be volatile and subject to downward pressure.” said Todd Schubert, head of Fixed Income Research at Bank of Singapore Ltd. Much will also depend on whether depositors believe the policy can actually be implemented, according to Brendan McKenna, coin strategist at Wells Fargo in New York. “At the moment, Turkish institutions do not have much credibility, so there may be challenges for pound depositors to participate,” McKenna said.

5. What could cause the mechanism to collapse?

Details have not been published yet. If the new mechanism fails, then the Treasury will have to find the money to compensate pound holders for their losses. The central bank, in turn, is likely to print money, further undermining the pound, according to Wolfango Piccoli, co-chairman of consulting firm Teneo. And if the new tool manages to stabilize the pound, the real exchange rate will rise, undermining the supposed competitiveness of a weaker currency that is key to boosting Turkish exports, a pillar of the government’s new economic model, he said.

Petros Kranias

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