On the night of May 28, Turkish President Recep Tayyip Erdoğan took to the podium and gave his victory speech. Following an election day whose results defied both domestic polls and international betting markets, Erdoğan thanked his supporters and gave a speech which mixed conciliatory messages with partisan rhetoric. The content of the speech, however, was less surprising than the location where it was delivered. Erdoğan stood on the balcony of the presidential compound, a lavish new residence and official complex completed in 2014, which the president had constructed in defiance of court rulings and opposition protests.

The situation highlighted the paradox of the entire Turkish election. After a year of record inflation, historic lows for the Turkish lira and a devastating series of earthquakes, all odds seemed to favor the opposition. However, the economic difficulties faced by Turkish citizens did not dissuade a majority from voting for Erdoğan. On the night of his victory, the president spoke from the balcony of a compound that had cost north of $600 million, or about 15 billion liras at today’s exchange rate. He addressed supporters—many from low income brackets—who had seen their lira savings erode and their cost of living double in the last 18 months. Several observers questioned the choice of platform and asked how citizens could freely elect a leader whose policies created such tangible difficulties.

Harnessing the economy as a rhetorical tool

It has been argued that Erdoğan’s victory depends on his constituency’s willingness to ignore the state of the economy. After all, economic crises generally bode poorly for incumbent governments. In Turkey this effect should hold doubly true, since Erdoğan’s unorthodox views on economics—in particular his insistence on slashing interest rates—directly contribute to inflation and the depreciation of the lira. While supporters might hope that Erdoğan’s unorthodox position on interest rates could be vindicated in the long run, it would make sense to avoid mentioning economic topics at a time when the pain is still so acutely felt by every family in the country.

Yet the Erdoğan campaign chose a different approach, bringing the economy to the forefront of political rhetoric. In the leadup to the election, Erdoğan promised to continue slashing interest rates, encouraged citizens to take pride in the lira and even highlighted his own economic bona fides. Over the past years, these messages have been wrapped in rhetoric that’s unusually politicized for such economic topics, with the president going so far as to state, “If they have their dollar, we have our Allah.” Pro-Erdoğan commentators frequently argue that Western governments try to undermine the Turkish economy and devalue the lira. In Erdoğan’s words, his policy constitutes nothing short of an “economic war of independence” where Turkey is “fighting against the interest rate lobby” and “enemies of production and employment.”

This rhetorical approach works surprisingly well. Erdoğan can pinpoint how slashing interest rates helps Turkish citizens in direct ways, by easing access to mortgages and commercial credit. Even the approval rates for loans reflect this political strategy, with small and medium-sized businesses, domestic employers, lira-heavy corporates, and export-oriented firms seeing a steep rise in credit approvals. Meanwhile, the second-order effects of slashing interest rates—namely the slump in demand for liras in international currency markets and the inflation caused by higher costs for importers and increased spending by domestic consumers—are too abstract for most citizens to consider. This leaves Erdoğan with a unique ability to claim credit for the benefits of low interest rates while blaming the more indirect negative consequences on foreign actors. 

A uniquely receptive audience

Turkish economic history lends tailwinds to Erdoğan’s narratives on the economy. Interest rates in Turkey have historically been high by Western standards. Even in the last five years, Erdoğan occasionally made concessions that allowed the central bank to significantly raise its policy rate—with the results usually proving very short-lived. Turkish citizens have witnessed a steady and seemingly inexorable weakening of their currency, regardless of different interest rate policies. This peculiarity has led some Turkish economists to infer that Turkey must deviate from developed countries in its economic policy. Considering the experience of the average household, it is easy to understand Turkish citizens’ aversion to conventional economic wisdom and their openness to strong rhetoric on economics. 

Another aspect of Turkish economic history lends credence to Erdoğan’s arguments. Historically high inflation and the unpredictability of the lira’s exchange rate in the 80s and 90s—well before the first Erdoğan government—led citizens to change domestic assets into foreign currency deposits. This “dollarization” of the Turkish economy has continued, with 56% of deposits now held in foreign currency or gold. Such dollarization carries risks for countries since it reduces the government’s monetary control, creates more volatile inflation, and raises risk in the banking system due to uncovered foreign liabilities. Moreover, the concept of dollarization relates directly to the debate on interest rates. Historically high interest rates made borrowing in liras unattractive to most Turkish citizens, and the resulting preference for dollar-based loans contributed to the liability dollarization of the Turkish economy. The increasing preference for dollars among the domestic population further exacerbated the instability of the lira.

Clearly, dollarization cannot be blamed on foreign actors, since Turkish citizens made their own decisions to open dollar accounts and take dollar-based loans. However, viewed as a characteristic of the current economy, Turkish citizens understandably worry about the predominance of foreign currencies and the instability this causes for the lira. Erdoğan’s economic messaging astutely builds on this concern, harnessing patriotic and anti-dollar slogans to support the multiple de-dollarization policies the government has implemented over the past years. Even from a conventional economic perspective, de-dollarization efforts hold merit, although the social consensus around them is built with simplified explanations.

Naturally, the label of de-dollarization should not exempt individual policies from scrutiny. Certain measures, such as Erdoğan’s flagship policy of slashing lira-based interest rates, can cause harm even if they nominally contribute to de-dollarization. But to truly understand how these policies are received by the majority of the population, observers must acknowledge Turkey’s unique historical experience with high interest rates and an overly dollarized economy. These factors make Turkish voters more receptive to the kind of political rhetoric and economic experimentation that Erdoğan has pursued.

The dangers of raising rates

A further characteristic of Erdoğan’s economic narrative is that it constrains any attempt to change course. In the leadup to the May elections, opposition leader Kemal Kılıçdaroğlu criticized Erdoğan’s economic policies and signaled his intention to reassert the independence of the central bank. However, he kept relatively silent about concrete plans to raise interest rates. His hesitation is understandable because the Turkish economy now runs on the cheap access to capital Erdoğan has enforced. With inflation still above 40%, a hypothetically victorious opposition government would have needed to raise rates drastically—potentially targeting a central bank policy rate between 30% and 50%—to quickly bring the real (inflation-adjusted) interest rates out of the red. 

Households would immediately feel the burden of such a dramatic rate increase, as consumer loans, credit card debt and mortgages become prohibitively costly, the equity value of real estate property falls, and corporate credit dries up. Meanwhile, Turkish banks would experience similar issues. Government regulations require banks to buy government bonds, which drives down Turkish bond yields and thus artificially reduces the worth of these bonds as assets to the banks. Rapidly increasing interest rates would widen this spread and leave banks with strongly under-valued bond assets on their balance sheets. 

Coupled with currency instability and a presumably higher ratio of non-performing loans, banks would therefore be hard-hit by a steep rate increase. Their capital adequacy ratio (the portion of the bank’s outstanding loans that are covered by their assets) would fall from 17% to an estimated 12%—risky territory by Turkish standards. Banks would respond by severely cutting back lending and imposing tougher conditions for credit approval, thus further restricting the economy’s access to capital. In such an extremely tight monetary environment, corporations would respond with layoffs, possibly putting the economy on track for a true recession. 

Given the severity of these impacts, Kılıçdaroğlu and his allies found their range of maneuver constrained. After all, it is impossible for a politician to campaign on a recession platform. Erdoğan could credibly communicate a message centered on employment and growth, arguing that millions of jobs depend on him remaining in power and continuing his loose monetary policy. Meanwhile, voters began to associate the opposition and their international advocates with the prospect of recession and unemployment, which rendered the electorate more receptive to Erdoğan’s rhetoric on foreign threats to the economy.

The dangers of not raising rates

Understandably, the Erdoğan campaign neglected to highlight one fundamental fact about the economy: that recession may be inevitable even if the president stays in power. As late as last year, the government might have hoped Turkey could use its high growth—7.6% year-over-year in the second quarter of 2022, now down to a still-strong 4%—to “outgrow” inflation. This view is made more attractive by the fact that Turkey does not have a classic fiscal problem and avoided steep deficits in the years leading up to the election, thus eliminating one of the root causes of inflation found elsewhere in the world. But severe risks attend Turkey’s extraordinarily loose monetary policy, primarily in the form of continued currency depreciation. The lira has already fallen more than 20% since the election. Despite recent loans from foreign governments and foreign currency loans from Turkish private banks, the central bank has exhausted most of its convertible foreign exchange reserves in a bid to prop up the lira prior to the election. This leaves no ammunition to respond to future fluctuations.

This circumstance holds three distinct dangers for Turkey. First, in a country so heavily dependent on imports, a drop in the value of the lira immediately raises costs for Turkey’s many importers, who then pass on these costs to consumers in the form of higher prices. The central bank has exhausted its tools to directly strengthen the lira, leaving Turkey more vulnerable than ever to this form of pass-through inflation.

Second, Turkey may find itself in a balance of payments crisis, where the stock of foreign currency available proves inadequate to cover the cost of imports. The influx of foreign currency during the summer tourist season can delay this crisis. However, increased demand for energy imports during the winter looms large. Turkey no longer has the resources to cover the gap, even if some natural gas from Russia can be imported on credit. 

Third, Turkey experiences a surprising degree of balance sheet risk. Despite a historically healthy fiscal policy and low public debt, Turkey’s central bank hosts a number of “hidden” liabilities. In its search for foreign currency to support the lira, the central bank has frequently borrowed dollars from Turkish commercial banks. The result has been to migrate the foreign currency balance sheet risks of private banks to the public sector. The central bank will need to find the foreign currency to cover eurobonds it didn’t issue, as well as the liquidity to reimburse private banks’ dollar deposits should people ever try to withdraw their money. With the central bank’s foreign exchange reserves exhausted, the only way these obligations can be met is by selling liras—thus further weakening the exchange rate.

What does the future hold for the Turkish economy?

While rate increases cannot directly regenerate foreign exchange reserves, a significant rate hike could theoretically ease the effects of these crises. Bringing inflation-adjusted interest rates above zero would dampen domestic spending by making deposits more attractive, thereby curbing inflation. Higher interest on lira deposits would also attract foreign investors to buy liras, thereby potentially ending the currency’s downward spiral while restoring foreign exchange reserves thanks to an uptick in FDI. 

In the weeks following the election, the imminence of multiple crises led many observers to believe that Erdoğan had no option but to backtrack on his long-held position and raise interest rates. Signs appeared that Erdoğan himself—along with key coalition partners—had begun to consider the idea. The reinstatement of former Merrill Lynch economist Mehmet Şimşek to the post of finance minister and the tapping of former First Republic executive Hafize Gaye Erkan to lead the central bank highlighted this possibility. International financial institutions watched eagerly, predicting that the policy rate—kept at 8.5% since March—would rise drastically to somewhere between 20% and 40%.

Once in their new positions, however, Şimşek and Erkan found themselves constrained by the same problems that plagued the opposition on the campaign trail. Much of the credibility built by Erdoğan during this election hinges on his ability to stick to his economic views, grow employment, continue providing benefits and avoid the kind of recession that voters feared from a Kılıçdaroğlu administration. Any interest rate hikes that drastically tightened the economy’s access to capital would ripple through the job market and evaporate credit. A significant change would prove especially dangerous for the ruling party as the country prepares for local elections next March, where Erdoğan’s AK Party will seek to regain control of the Istanbul and Ankara mayor’s offices.

As a result, when the central bank’s Monetary Policy Committee on June 22nd finally announced an increase in its policy rate from 8.5% to 15%, observers were disappointed. With inflation still at 40%, real interest remains squarely in the negative zone. While some analysts believe that further gradual hikes may follow—a position expressed by Erkan herself—the market shows unequivocal pessimism. Instead of the increase in value that economists expected from a rate hike, the lira fell a further 7% against the dollar. Ironically, this depreciation may further discredit conventional economists and make the Turkish population even more receptive to Erdoğan’s unorthodox views. It could also serve as a rhetorical tool to justify a return to Erdoğan’s usual interest-slashing policies.

The observers now surprised by the lackluster hike in the policy rate are ignoring the fundamental lessons of Erdoğan’s economic rhetoric over the past three years. The president’s insistence on low interest rates is more than a personal belief: it is a core tool of political communication. Instead of avoiding economic discussions, Erdoğan brought the economy to the front and center of campaign rhetoric. The president harnessed Turkish citizens’ unique openness to interest rate experimentation while shrewdly embedding economic topics in the core messages of national pride and self-reliance that increasingly motivate the electorate. Meanwhile, the opposition found itself tainted by the fact that a radical pivot on interest rates would end access to cheap capital and endanger jobs—the same dilemma that now constrains Erdoğan’s own finance minister.

It should not surprise us that Erdoğan proved willing to moderately raise rates on June 22nd. Several precedents exist for such a move—and all have proved temporary. Much like in past rate hikes, Erdoğan is ardently voicing that his fundamental position on interest remains unchanged, and that it is a “delusion” to think otherwise. The counterintuitive fall of the lira after the June 22nd announcement may help cement his view. We must therefore not conclude that the Turkish government is pivoting to a conventional economic stance. Difficult times lie ahead, when the electorate’s vote of confidence in Erdoğan’s unorthodox monetary policy must be balanced with the need to fix looming economic crises. It will not be an easy task. 

[Lane Gibson edited this piece.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.