In geopolitics and in finance, August 18 was a big day for Turkey. President Recep Tayyip Erdoğan made his first visit to Ukraine since the Russian invasion, meeting his counterpart Volodymyr Zelenskyy and United Nations secretary general António Guterres, partly to try to lay the ground for peace talks with Russia.
Meanwhile, back in Ankara, the Turkish central bank shocked international markets by cutting rates, even after inflation rose to almost 80% in July. Given the frequency of changes in leadership at the Turkish central bank, the rates decision might have been playing on Erdoğan’s mind as he met with Zelenskyy and Guterres in Lviv.
The cut is designed to prop up economic growth, a central concern for Erdoğan ahead of elections next year. But it will lead to even higher inflation, putting more pressure on the lira. It runs contrary to all conventional economic wisdom and, for many investors, further highlights the dangerous sway Erdoğan has over the central bank.
[The rate cut] runs contrary to all conventional economic wisdom and, for many investors, further highlights the dangerous sway Erdoğan has over the central bank
One Ankara source familiar with interest rate dynamics in Turkey notes that the precise details of the cut (100 basis points, to 13%) are less important than the signalling effect of cutting rates at all while inflation soars. “It shows that the central bank is not at all interested in price stability,” says the source.
It is true that Turkey is exposed to global rises in energy and commodity prices, because of its reliance on imports and its emerging-market susceptibility to higher dollar rates. That said, inflation is much higher in Turkey than other energy-poor emerging markets, not least because of central bank rate cuts in late 2020, when inflation had already risen to 20%.
Analysts say that the central bank is feeling bolder because of a rise in reserves in late July, after they fell to a 20-year low in June. It is therefore slightly better positioned to intervene in the currency market to defend the lira. A good tourism season has helped, but the bump in reserves is thought to be due primarily to $15 billion of deposits in Turkey, as reported by Bloomberg, from Russian state nuclear energy company Rosatom, which is building a $20 billion power plant in Turkey.
Foreign policy
Turkey’s foreign policy is a critical factor in its financial position. It has sought to bolster reserves through currency swaps with countries such as China, Qatar and the UAE – and potentially, according to reports, with Saudi Arabia, after a visit by Saudi crown prince Mohammed bin Salman to Turkey in June.
Meanwhile, Turkey has maintained economic relations with Russia (on which it depends for gas imports), even in the face of stringent Western sanctions. In early August, Erdoğan boasted that five Turkish banks were now using Russia’s Mir payments system, after a meeting he held with Russian president Vladimir Putin.
That could make things easier for Russian tourists, who are one of Turkey’s most important sources of tourism revenue. But Turkey is also dependent on the West – via the international financial system – in a way that Russia never has been, due to an annual external financing requirement of more than €200 billion.
Turkey’s economic health is also, in part, a question of the strength of its banks. Despite sky-high inflation, profit in the sector has soared this year, with some banks posting returns on equity of more than 40%. That is thanks to inflation-linked bond portfolios, strong loan growth and low credit costs. But it might not be enough to compensate investors, as the post-inflation return on equity has fallen to mid-single digits, says a source at a big private lender.
In any case, these highly dollarized banks are increasingly implicated in the rates quandary. Late last year, Turkey tried to stem demand for foreign exchange through a programme to compensate lira depositors for falls in the value of the currency. Although negative real deposit rates will not attract much of a switch from dollars, the government has used tax incentives to encourage corporate depositors to stay in the programme.
The problem is that the US, through sanctions, has more power to bring about a collapse in the Turkish financial system than it has to prop it up
This won’t stop depositors from trying to exit the system entirely if they fear capital controls and outright collapse. Because of Turkey’s external imbalances, secondary sanctions by the US against it for keeping the door open to Russia could all too easily trigger such a collapse – leading to a crisis in confidence that might lead to dollar-deposit outflows, at least at some banks, and put a halt to Turkish banks’ annual syndicated loan outings with international lenders.
The last time Turkey came close to a deeper financial crisis, in 2018, it was also in large part due to fraying relations with the US – notably an Iran sanctions evasion case, which stemmed international and local foreign currency liquidity at Halkbank, one of the biggest state-owned lenders.
Use of the Mir payments system is not an obviously sanctionable action, argues a prominent Turkish foreign policy analyst, who thinks Turkey would otherwise have avoided it. And Erdoğan clearly reckons it is beneficial for Turkey to maintain friendships on both sides of the Ukraine conflict. A similar policy in India is also partly driven by dependency on energy imports, but Turkey’s financial position is much weaker than India’s.
This is a delicate balancing act. Secondary sanctions would be targeted, says the foreign policy analyst. That may be some source of comfort for the wider system, especially private banks. The problem is that the US, through sanctions, has more power to bring about a collapse in the Turkish financial system than it has to prop it up.
