Turkish economy enters a vicious circle – Inflation and Devaluation

For quite some time, Turkey’s debt has been rising, its currency has been losing value, and inflation has been picking up. When I wrote about the Turkish economy in Q3 2017, the figures suggested the possibility of a boom.

But I also identified some challenges, including fighting inflation and restoring investor confidence. But like most prognosticators, I did not predict the COVID-19 pandemic, which now threatens to send the country over the edge into economic crisis.

Turkish lira loses value rapidly

The value of the Turkish currency has fallen sharply against the euro since 2018 and now is half of what it was at the end of 2017. Compared to the zloty, the currency of Poland, another emerging and developing European economy with a much more stable currency, the lira appears to be in a steady devaluation slope.

Several factors have led to the devaluation of the lira. Demand for the currency is lower than its supply due to a variety of factors: the low competitiveness of many sectors and the resulting current account deficit, political turbulence, the Turkish central bank’s lack of independence, and high inflation, to name a few.

Turkish economy: Devaluation drives up inflation

A devaluation of the domestic currency, in turn, makes all imported goods more expensive. Consumers have to spend more on foreign consumer products. For Turkish companies, imported inputs become more expensive, too.

This is particularly problematic when it comes to raw materials and intermediate products for which there are no domestic substitutes. The higher-priced inputs increase the cost of production. Turkish consumers have to pay for this. Over the past three years, the annual average inflation rate in Turkey has been over 12 percent.

Such a sharp rise in prices is particularly problematic for low-income households. For them, it will become increasingly difficult to pay for urgently needed basic necessities.

This high inflation rate exacerbates the devaluation trend: If inflation causes Turkish companies’ production costs to rise, they can no longer sell their products abroad. If foreign countries demand fewer Turkish products, demand for the Turkish lira falls. If demand for the Turkish currency declines, the lira continues to lose value, and prices in Turkey rise, contributing to a vicious circle of inflation and currency devaluation.

Current account deficits drive up external debt

High and rising inflation also has an impact on a country’s foreign economic development:

• High prices have a negative impact on a country’s exports, so less export revenue is generated.
• When prices for domestic products rise sharply, consumers switch to imported products. This is worthwhile if the inflation-induced price increase of domestic products is greater than the devaluation-induced price increase of imported products—import spending increases.

When falling export revenues meet rising import expenditures, a country spends more than it earns in foreign trade. The result is a current account deficit because a country’s current account captures these foreign trade activities.

If a country spends more on foreign trade than it earns over a period of many years, it must borrow the resulting shortfall abroad. The result is an increase in the external debt of the entire economy.

Between 2010 and 2020, Turkey’s foreign debt grew from $291 billion to $450 billion. This increase is faster than the growth of Turkey’s gross domestic product (GDP). Therefore, foreign debt has increased sharply as a percentage of GDP: Ten years ago, foreign debt accounted for about 37 percent of Turkey’s GDP. In 2020, it was almost 63 percent.

With a weak currency that suffers from devaluation, foreign debt is problematic. In this case, foreign lenders require Turkey to take out its loans in hard currency (dollars or euros). Interest payments and repayments must also be made in dollars or euros. If the Turkish lira loses value, more and more lira must be spent on debt service.

Declining growth and rising unemployment

Turkey’s annual GDP growth rates have been declining for around ten years. The exception was 2017, when the government massively supported growth through higher government spending, government credit subsidies, and tax cuts. As feared this was only an economic flash in the pan.

In recent years – even before the outbreak of the Corona pandemic – the Turkish unemployment rate was rising – reaching almost 14 percent in 2019. High inflation rates are reducing citizens’ purchasing power and increasing the cost of living enormously.

Domestic and foreign investors are withdrawing their capital from Turkey to avoid the loss of wealth resulting from high inflation rates and the depreciation of the Turkish lira. This flight of capital means that there is no capital for investment.

What needs to be done?

In my view, the most important economic policy measure is to curb inflation quickly. If this is successful, the international competitiveness of Turkish companies will improve, increasing employment. Higher exports will mean growing demand for the Turkish currency.

That stops the devaluation trend. For investors, it then becomes more attractive to invest capital in Turkey. Capital flight can then be stopped. And consumers regain purchasing power.

Fighting inflation requires a reduction in the money supply by the Turkish central bank and an associated increase in interest rates. However, it is precisely this measure that has met with massive resistance from the Turkish president, Recep Tayyip Erdoğan.

At the end of March, he dismissed the head of the central bank, Naci Agbal, because he raised the key interest rate. Despite this lack of central bank independence, It is to be hoped that it will nevertheless be able to quickly implement the necessary interest rate hikes anyway.

In addition, there is good reason for Turkey to intensify its efforts to cut a deal with the European Union on modernizing the customs union between the two blocs. As our 2016 study has shown, Turkey stands to reap sizeable economic profits from closer Turkish-European integration in services and agricultural trade.

Despite the much-hyped diplomatic snub against EU Commission President Ursula von der Leyen (“Sofa Gate”), the meeting between her, EU Council President Charles Michel, and Turkish President Recep Erdoğan has produced some positive signs on how to move ahead.

For the sake of the Turkish economy, we should hope that Erdoğan does not continue to jeopardize the relationship with more erratic and repressive policies.