The Coup in the Kremlin
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Turkish Prime Minister Recep Tayyip Erdogan is no fan of high interest rates. He has repeatedly argued that his country’s central bank should keep real lending rates at or near zero. (A devout Muslim, he is said to draw inspiration from Islamic doctrine, which forbids interest.) Occasionally, he has gone so far as to dispute a fundamental tenet of economics, claiming that high interest rates cause inflation. He has even pinned part of the blame for his political troubles -- including mass protests last summer and an ongoing corruption scandal this winter -- on an unholy alliance of international financiers, Western governments, and the foreign media that he has dubbed, tellingly, the “interest rate lobby.”
Erdogan’s personal faith in low lending rates could be dismissed as just that -- personal -- were it not for the ways it seemed to sway Turkey's monetary policy. Up until two weeks ago, Turkey’s central bank had increased rates only three times over the past two years, reluctantly and ever so slightly. When it did so last August, by half a percentage point, a move that most analysts decried as too little and too late to offset creeping inflation, it followed up with a vow to steer clear of rate increases in the near future. It was, to many observers, a dangerous sign that the bank had forfeited its independence to indulge Erdogan’s interest rate credo and his emphasis on continued economic growth. The central bank, economist Tim Ash wrote in a note emailed to investors following the August rate hike, appeared “much more concerned about … helping the government achieve its 3 to 4 percent growth target” than about keeping the lira strong and keeping inflation at bay.
It was to the relief of many market watchers, then, that on the night of January 28 this year, despite Erdogan’s earlier insistence to the contrary, the central bank raised the overnight lending rate by about three percent.
It appeared to have no choice. Despite Başçı’s August prediction that it would finish the year at 1.92 to the dollar -- and despite billions spent to hinder its slide -- the lira had entered 2014 at 2.15. In the weeks that followed, it fell even further. A day before the bank’s intervention, it nosedived to 2.39. Afterward, the lira momentarily recovered some of its losses, strengthening to 2.16, then dipped again, before stabilizing near 2.20. The flames of the incipient currency crisis have been put out, at least for now.
For Erdogan, the rate hike has come as a mixed blessing. It may have salvaged the central bank’s reputation and placed the lira on firmer footing, but it has also placed the prime minister’s most treasured political currency -- growth -- at risk. A day after the bank’s emergency meeting, JPMorgan Chase revised its 2014 economic growth forecast for Turkey from 2.5 to 1.9 percent. Bank of America Merrill Lynch cut its forecast from 3.5 to 1.7 percent. On February 7, Standard & Poor’s cut its outlook on Turkey’s ratings to negative, citing risks of a sharp economic slowdown.
Turkey has generally been considered an economic success story over the past decade, and with good reason. Since 2002, Erdogan’s first year in power, GDP has grown by an average of five percent annually. Foreign investment (FDI) has poured in at unprecedented levels. Only a quarter of Turks had been considered middle class in the mid-1990s; today, 60 percent of the country would make the same claim. Inflation has been low, and the banking sector has proved resilient.
The U.S. Federal Reserve’s quantitative easing (QE) program, which flooded international financial markets with tens of billions of dollars every month, ushered in a new era for Turkey’s economy. As the Fed’s bond purchases took off in 2008, investors, flush with cash and seeking greater returns than they could find in the United States, rushed to emerging markets like Turkey’s. Powered by short-term investments in Turkish securities, low lending rates, and a surge in consumer demand, Turkey’s economy took off. GDP growth reached rates of nine percent in 2010 and 2011 -- comparable to China’s -- before slowing to 2.2 percent in 2012 and a projected 3.6 percent last year.
That era is over. With the Fed preparing to turn the tap off on its bond-buying program, capital flows to Turkey are beginning to dry up, leaving behind evidence of an economy dependent on cheap credit. The current account deficit has swelled to about $60 billion, or seven percent of GDP. Businesses and consumers, particularly those who took out loans in foreign exchange, are facing a mountain of debt. At the end of 2013, the volume of bank loans to surpassed a trillion lira ($450 billion), a twofold increase since 2010. The domestic savings rate is the lowest in 30 years.
There are also mounting concerns that the new wealth has been misspent. A corruption inquiry launched in December has since churned out evidence of kickbacks, rigged tenders, and suspicious links between Erdogan’s Justice and Development Party (AKP) and Turkey’s construction industry, although the fast-changing landscape of Turkish cities -- which now sparkle with newly built housing estates, office towers, and shopping malls, and the continued construction of massive government infrastructure projects -- already gave plenty of grounds for suspicion.
Meanwhile, structural reforms have been lagging behind. Turkey’s growing population has traditionally played to the country’s economic advantage, but recent analyses suggest its potential is being neglected. In a 2012 survey, Turkey placed 44th out of 65 countries in mathematics, reading, and science skills among 15-year-olds. The average duration of schooling for Turkish 25-year-olds remains only 6.5 years, placing it in the bottom half of the 187 countries studied by the UN’s 2013 Human Development Index. Perhaps the biggest brake on sustainable growth is the woefully low labor force participation rate among women. At 29 percent, it is about half of the OECD average.
Without further reforms in education, labor, and women’s rights, as well as investment in high-tech exports and improvements in the business climate, a recent IMF report warns, Turkey will find it difficult to generate growth of more than three percent per year, much less meet Erdogan’s target of becoming one of the world’s ten biggest economies by 2023. “Turkey’s consumer-driven economic model cannot sustain consistently high growth rates,” another study concludes, “undermined [as it is] by low investment and savings rates, limited export sophistication, pervasive gender inequality and inefficient use of its ‘demographic dividend.’ ”
With the boom years in its rearview mirror, Turkey may have wasted a golden opportunity to address such issues, says Ugur Gürses, a financial columnist with Radikal, a Turkish paper. “Emerging markets, Turkey in particular, had room to manage their garden, to implement some reforms,” he says. “We just [wasted] the really precious time in the last five years, and right now it may be too late.”
In the short term, the end of the era of high growth may spell rough seas ahead for Erdogan and the AKP. As the January 28 interest rate hike has made clear, the economic landscape is shifting beneath Erdogan’s feet. It’s not entirely clear whether he’ll be able to keep up.
The public is unlikely to feel the economic downturn for at least another few months, which means the AKP may still do reasonably well in local elections set for March 30. But the end of the era of cheap credit and high growth could bode ill for Erdogan if he competes in this summer’s presidential election, as he is expected to. The corruption scandal, having implicated four of his ministers, has already eroded the Turkish leader’s support. In a survey conducted in mid-January, his approval rating dipped to 39.4 percent, down from 48.1 only a month earlier and a far cry from his 59.1 percent rating at the end of 2012. An economic slowdown may wreak further havoc on his political ambitions, exacerbating the damage from the ongoing corruption scandal. “A reasonable number of people may be willing to forget about corruption provided the government delivers growth and jobs and welfare and things like that,” says Asaf Savaş Akat, a professor at Istanbul’s Bilgi University. “If the government cannot do that, then the corruption issue may start to hurt.”
In the short term, Erdogan will have to live not only with the effects of the interest rate hike but also with a political crisis partially of his own making. Having resorted to strong-arm tactics, conspiracy theories, and a purge of the bureaucracy to defuse the ongoing corruption probe, Turkey’s leader has put his government’s biggest legacy -- political stability -- to the test. That alone, regardless of growth forecasts, interest rates, and the relative strength of the lira, threatens to scare off investors, at least according to Muharrem Yilmaz, chairman of Turkey’s largest business association.
Turkey is “a country where the supremacy of law is not heeded, where judicial mechanisms don’t operate with EU norms, where the independence of regulatory institutions is tainted, where there is pressure on companies through tax penalties and other punishments, where legislation on tenders is changed regularly,” Yilmaz, the head of the Turkish Industry and Business Association, said in a speech on January 23. “It is not possible for foreign capital to come to such a country.”
Erdogan responded the next day. Yilmaz’s words, he said, amounted to “treason.”