Erdoğan’s Gamble with Turkey’s Economy

In 2011, then Prime Minister Recep Tayyip Erdoğan set ambitious economic goals for 2023, the centenary year of the founding of the republic, aiming to make Turkey one of the ten largest economies in the world with a GDP of $2 trillion and a per capita GDP of $25,000. With just over a year to go until 2023, however, Turkey is far from achieving these objectives and the economic situation is deteriorating. Per capita GDP was $8,500 in 2020, down from $12,600 in 2013.

Not only does the economy suffer from long-standing structural problems, it is also increasingly victim to the monetary and other policy choices of the country’s leader. As a result, Turkey is experiencing a currency crisis with serious economic and social repercussions. Yet, as the country prepares for presidential and parliamentary elections in 2023, the government’s economic policy choices risk doing more damage to the economy than alleviating the problems. Identity politics, political polarization, and nationalism have dominated politics in recent times, but it seems that the economy will decide the country’s political future this time, as it did after the 2001 economic crisis that helped bring Erdoğan’s Justice and Development Party (AKP) to power.

Yet, as the country prepares for presidential and parliamentary elections in 2023, the government’s economic policy choices risk doing more damage to the economy than alleviating the problems.

After successive economic crises and triple-digit inflation in the 1990s, 2001 was decisive a decisive year for Turkey’s macroeconomic stability and integration into the global markets. That year, it began to implement a far-reaching economic program, supported by the International Monetary Fund, with important structural reforms. The following year, the AKP continued these reforms once in office combined with some of its own – with success. GDP more than tripled between 2001 and 2013, reaching a high point of $957 billion. Foreign direct investment flows increased from $982 million to $19.2 billion between 2000 and 2015. After the establishment of the Customs Union with the EU in 1996, the volume of trade between the two sides increased steadily. Turkey also diversified and increased its trade with the Middle East and Africa. Exports increased fourfold between 2001 and 2008, exceeding $130 billion in 2008.

The Economic Miracle Is Gone

However, since 2015, the economy has lost its dynamism, and it has been in a recession since 2018. Turkey has been experiencing economic fragility with the lira under pressure, high inflation, high unemployment, and high private debt. This has caused a record depreciation of the currency and inflation has been in double digits. Therefore, the economy was already suffering from structural deficiencies when it was hit by the coronavirus pandemic in 2020.

Most of the structural reforms started when Kemal Derviş was the minister of state in charge of economic affairs from 2001 to 2002. These covered the independence of the central bank, public-debt management, transparency in public procurement, the reduction of subsidies, and the establishment of independent regulatory and supervisory agencies. They were maintained in the early years of the AKP rule, starting in 2002, but have been gradually reversed in later years.

The global financial crisis of 2008 hit the economy hard. The effects of the crisis in Europe had a significant impact on the economy as the EU is Turkey’s most important export market and main source of investment.

As a result, the economy remained dependent on capital inflows or “hot” money from abroad, mostly in the form of short-term capital. This led to an escalation of private debt denominated in the U.S. dollar.

In the aftermath of the crisis, quantitative easing by the major central banks caused a large flow of capital into emerging markets, which Turkey benefited from. This led to a rapid expansion of credit in the country, much of it channeled to the construction and real-estate sectors. The economy continued to grow at high rates, but the low rate of savings—one long-standing vulnerability—did not improve. As a result, the economy remained dependent on capital inflows or “hot” money from abroad, mostly in the form of short-term capital. This led to an escalation of private debt denominated in the U.S. dollar.

In the late 2000s, Turkey’s accession process with the EU also began to slow down and the political and economic reform processes in the country came to a halt.

The Economy Is a Victim of Politics

Political risk for investors in Turkey has increased over the last decade. With the anti-government demonstrations in 2013, the accusations of corruption against Erdoğan and cabinet members at the time, and the rising problems between the Gülenists and the AK Party, Turkey entered an era marked by political crises of varying intensity. This lasted until the failed coup attempt of 2016.

These political crises coincided with the growing instability in the Arab world, the war in Syria, and the collapse of the Kurdish peace process and major deterioration of the security situation in Turkey, particularly in the Kurdish-majority southeast. The war in Syria has had direct and indirect economic impacts on Turkey, in particular the cost of dealing with over 4 million refugees and of military operations in Syria as well as of maintaining border security.

During the same period, relations with the United States and the EU, the two most important sources of investment in Turkey, reached an all-time low. Turkey’s dependence on capital inflows means that a sudden change in the risk appetite of investors can have a significant impact on macroeconomic indicators. As an illustration of the problem, in 2018, when U.S. President Trump on Twitter threatened Ankara with sanctions, this led to a sharp depreciation of the lira, after which the economy stagnated.

As a result of these problems, of the erosion and eventually practical elimination of the independence of the Central Bank of Turkey (CBTR), and of unorthodox monetary policies, the economy has faced significant challenges in recent years.

When the coronavirus pandemic struck in 2020, Turkey was already suffering from a record depreciation of the lira and a depletion of foreign-exchange reserves to counter this, as well as from double-digit inflation for the previous two years. The pandemic has deepened the country’s economic difficulties. The turmoil has caused a strong downward spiral of the lira and inflation has fluctuated in the double digits, standing at 20 percent currently. The official unemployment rate exceeded 13 percent and youth unemployment 25 percent in 2020.

As a result of these problems, of the erosion and eventually practical elimination of the independence of the Central Bank of Turkey (CBTR), and of unorthodox monetary policies, the economy has faced significant challenges in recent years. The CBTR kept its benchmark interest rate below the inflation rate, which increased the demand for foreign currencies, especially given the negative real interest rate. It responded to the strong downward pressure on the lira by selling large quantities of foreign currencies, depleting its reserves. As the CBTR’s reserves reached a very low level, depreciation of the lira became sharper. Last month, the CBTR cut its benchmark interest rate down to 15.5 percent, far below the official annual inflation rate of 20 percent. As a result, the lira depreciated by almost 30 percent in November alone.

As Turkey is dependent on imports, including for manufacturing its export products, every drop in the lira increases the cost of basic goods and makes life very difficult for the most vulnerable segments of the population. It also increases the foreign-exchange liabilities of the non-financial corporate sector whose debt is denominated in the U.S. dollar. In recent years, Turkey has had to roll over $200 billion in foreign debt annually.

The Motivation Behind the Policy

Orthodox theory recommends a tight monetary policy that will mitigate inflation by moderating domestic demand. In Turkey, by contrast, under the guidance of the presidency, the CBTR is pursuing a loose monetary and credit policy to boost economic growth, which Erdoğan needs desperately. He is concerned that higher interest rates will slow down the economy and fuel voter discontent in the run-up to the elections in 2023. He has therefore pushed the CBTR to cut rates in the hope that cheaper credit will stimulate the economy and improve his popular support.

Yet, the realities of the economy, particularly the rampant inflation, require a restrictive monetary policy at least until a semblance of macroeconomic balance is achieved. This is also needed for establishing credibility with investors, reversing the public’s preference for foreign currencies over the lira, and restoring the foreign-exchange reserves of the CBTR. The current monetary policy leads to exchange-rate volatility, high inflation, and a high risk premium. However, the government is convinced that a weaker lira will limit imports, boost exports, increase investment and production, and reduce the current account deficit and unemployment over time.

The government is taking a gamble that may cost the economy in the long run. Short-term policies may help to secure votes in the coming elections but they will not solve structural problems and vulnerabilities. What is needed instead is a long-term strategy, with sometimes very painful recipes, that will put the economy back on track. With a relatively low public-debt ratio at 40 percent, there is fiscal space for the government to support various sectors of the economy and the unemployed, particularly the more vulnerable households and companies during this difficult period.

Turkey is in a difficult economic situation with several challenges: high unemployment (especially among young people), the integration of millions of migrants, economic losses due to the pandemic (especially in tourism), high costs of the military interventions in Syria, Iraq, and elsewhere, and climate-change-related. Moreover, the pandemic is far from over, including in Europe, making it difficult for the world economy to rebound quickly. This is challenging for Turkey as it aims for export-led growth.

Instead of insisting on a growth model that will not solve the economy’s structural problems, Turkey’s policymakers should prepare the country for the social and economic challenges posed by the needed energy and ecological transitions, including the decarbonization of the economy. The success of this process requires huge investments in new technologies and will decide Turkey’s rank among the world’s economies in the future.