The Turkish economy, weathered by skyrocketing inflation and a plunging currency value, stands at a critical juncture. Following the undecided result on 14 May 2023, Türkiye is headed for a run-off election on 28 May between incumbent President Recep Tayyip Erdoğan of the Justice and Development Party and Kemal Kılıçdaroğlu, leader of the opposition Republican People’s Party.
In a conversation with OMFIF, Erich Arispe Morales, senior director of sovereigns at Fitch Ratings, discussed the importance of the election and the potential ramifications for the Turkish economy.
Now in power for over 20 years, first as prime minister and then as president, Erdoğan has overseen the consolidation of political power. Through institutional reform – most notably a 2017 constitutional referendum – economic policy-making has become much more centralised.
Upheaval and undelivered promises
One result of this institutional upheaval has been the country’s ‘unorthodox’ approach to monetary policy. Türkiye Cumhuriyet Merkez Bankası, the Turkish central bank, saw three governors between 2019-21. In 2021, Erdoğan dismissed Governor Naci Ağbal after he presided over two sharp interest rate hikes to rein in persistent double-digit inflation.
The unconventional theory behind the so-called ‘new economic model’, which lies at centre of the country’s economic and monetary policy-making, aims to enhance competitiveness in pursuit of an export-led growth model. It rests on the assumption that the combination of lower interest rates (thought to bring lower inflation) and targeted support to strategic, export-orientated sectors will lead to higher investment and more financing for exports. Exports will grow and, eventually, turn the current account deficient into a surplus.
But the implementation of this unconventional theory has not delivered on its promises. At the end of 2021, with inflation around 20%, ‘The central bank cut rates by 500 basis points despite increased inflation, deteriorating domestic confidence and a positive output gap, which resulted in an additional episode of financial distress,’ explained Arispe Morales. ‘In turn, this has led to increased external vulnerabilities, inflation being entrenched at higher levels and weaker policy credibility.’
As a result, due to ‘inconsistent policies that lead to high inflation, downward pressure on the lira and international reserves, and weigh on the availability and cost of external financing ,’ Fitch downgraded Türkiye by two notches in 2022 from BB- to its current rating, B. The outlook also remains negative.
Both Erdoğan and Kılıçdaroğlu have proposed different policy approaches to address these issues as part of their campaigns. The incumbent has defended the current policy mix, with the intention to maintain low interest rates and targeted regulations to manage currency and macroeconomic pressures. Arispe Morales noted that ‘The challenges of managing this will be significant.’
The opposition has indicated a return to a more conventional economic policy-making approach, focusing on inflation targeting to re-establish price and financial stability. Institutionalising central bank independence, reining inflation into the single digits through higher interest rates within the next two years and replenishing central bank reserves through capital inflows are main objectives for Kılıçdaroğlu.
What to watch out for
For Arispe Morales, the next government’s plan to ease pressures in the foreign exchange market and lower inflation, the trajectory of the lira, access to financing to meet large external borrowing needs and domestic politics, including the 2024 local elections, are all key factors to monitor.
Geopolitically, there are also a few things to watch. Syrian refugees in Türkiye could become a more divisive issue domestically, as the countries have begun normalising relations. Second, the relations between Türkiye and other regional powers such as Saudi Arabia, Egypt and the UAE could change the geopolitical dynamics in the greater Middle East. Finally, though the Turkish delegation eventually gave the green light to Finland’s Nato membership in March, Sweden’s accession is still on the table. The outcome of this process will shape the future of Türkiye’s relationship with the West, especially against the backdrop of the war in Ukraine.
Though geopolitics should not be discounted, economics are at the heart of this election. ‘The growing economic imbalances or distortions that are a result of [Türkiye’s] expansionary and unconventional policy mix are becoming more evident,’ said Arispe Morales. The country’s next leader ‘will have to deal with pent-up foreign exchange demand, pressures on the lira and a current account deficit, declining international reserves and still very high inflation.’
No matter the outcome on Sunday, the next government will face a challenging economic backdrop and political situation. But returning to sustainable, predictable and credible economic policy-making seems increasingly unlikely under Erdoğan’s leadership.
Taylor Pearce is Senior Economist at OMFIF.
For more on Türkiye’s economic outlook and what to watch for in the run-off election, listen to OMFIF’s podcast ‘The economic consequences of Türkiye’s run-off election’.