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Turkish Monetary Policy at the Crossroads

The Turkish lira has been declining in value for eight months, and the drop has accelerated recently. The decline of the lira has been part of a broader decline in emerging market currencies. However, the depreciation of the Turkish lira has been more extreme. Following the latest drop in the value of the lira, the Turkish central bank made a surprisingly large increase in interest rates on January 28th. The increase was publicly opposed by Prime Minister Erdogan, who has attributed attempts to raise rates to a vague “interest rate lobby”. The disagreement on interest rate policy between the central bank and the prime minister can be interpreted as an attack on central bank independence, although Mr. Erdogan publicly acknowledged the Bank’s independence. The move by the central bank also illustrates the limits on central bank influence imposed by the Policy Trilemma.

Traditional targets for monetary policy are interest rates, the exchange rate, and free international capital flows. According to the Policy Trilemma, a central bank can choose two out of three of the traditional policy targets, but not all three. Turkey has a floating exchange rate and unrestricted capital flows. Turkey’s large current account deficit relative to the size of the economy makes short-term borrowing especially important. Given these two targets, Turkey cannot also freely choose interest rates on Turkish lira-denominated assets. To be competitive with dollar and Euro denominated assets, Turkish lira assets must offer a higher interest rate when the lira is expected to depreciate, as it has recently. If Turkish rates do not contain a sufficient foreign exchange risk premium, investors will switch to more attractive assets, which induces a greater depreciation of the lira. The central bank, led by Governor Erdem Basci, has been selling reserves to resist lira depreciation, and the sharp increase in interest rates is an apparent admission that selling reserves was not sufficient to stop the lira depreciation.

A related issue is the beginning of the end of the global “high tide” of liquidity. Tapering of asset purchases by the Federal Reserve has already begun, and further tapering is a near certainty. Investors are adjusting their positions in anticipation of actions by the Fed. Currencies such as the Russian ruble, the Brazilian real, and the South African rand have also lost value against the U.S. dollar in January. However, the decline in the value of the Turkish lira has been among the most extreme, except for the collapsing values the Argentine and Venezuelan currencies. Thus, the recent move by the Central Bank of Turkey has just served to keep the depreciation of the lira in line with the fall of the ruble, real, and rand.

Resistance to higher interest rates by Mr. Erdogan is a bit of a puzzle, since his administration has pursued mostly free market policies that have contributed to  rapid economic growth.   He seems to appreciate the fact that prices of Turkey’s exports must be competitive with those of rivals. In an open economy, where investors freely move their money among countries, why are competitive interest rates not as important as competitive export prices?

A further important question is why the Turkish lira depreciated more than the real and ruble? A possible explanation is that investors’ risk assessment regarding Turkey is deteriorating more than their risk assessment of Brazil or Russia. This is likely to be related to recent political developments.

Central Bank Independence and Inflation

Countries without independent central banks have experienced high inflation rates and depreciating currencies. Prior to constitutional reform in 2001 the Turkish Central Bank was subordinate to the finance ministry. The Bank was obliged to finance budget deficits by printing money to buy bonds issued by the government. As a result inflation rates were high, reaching a peak of 104% in 1993. Major reform gave the Bank independence from the Finance ministry, and recent inflation rates have not exceeded 10% per year. The 2013 inflation rate of 8% was low relative to historical rates in Turkey, but it was higher than all EU countries, and higher than the central bank’s target rate of 5%. The relatively high and rising inflation rate has raised the question of how much de facto independence the central bank has in 2014.  Recent developments have also led critics to question how much judicial independence exists in Turkey today.

Countries without Central Bank Independence

World inflation rates are extremely low by historical standards, and some critics claim that EU inflation is too low. Prominent exceptions to low inflation are today are Argentina and Venezuela, which lack independent central banks. In addition to inflation, they both have depreciating currencies that governments have tried to restrain with controls on capital flows. As a result there are active black markets in which their currencies sell at a discount. In Argentina the government tried to conceal the true inflation rate by jailing private economists who produced their own index that showed a higher inflation rate than the official rate. President Kirchner of Argentina and President Maduro of Venezuela have blamed “international speculators” for currency depreciation, rather than inflationary monetary and fiscal policy. These  alleged ”anti-social speculators” have been described by Argentine and Venezuelan officials in the same terms as the “interest rate lobby” that Mr. Erdogan blames for the depreciating lira.  Turkey has some similarities with Argentina and Brazil, but there are also differences. Since Mr. Erdogan took office in 2002, Turkey has had a period of sustained economic growth that has raised income per capita to the level of several members of the European Union.

Conclusion

While it would be premature to declare the death of central bank independence in Turkey, the strong criticism of interest rate policy by Prime Minister Erdogan is a worrying sign. Ironically, rather than helping to stabilize the lira, the attack might contribute to a greater decline in the value of the Turkish currency, which would make the job of the central bank more difficult.  Investors might start asking questions such as:  Will Turkey return to its inflationary past by taking away the independence from the central bank?  Will they follow Argentina and Venezuela by implementing short-lived reforms that revert back to inflationary policies?

Turkey’s dependence on short-term capital inflows makes it vulnerable to changes in spreads between Turkish lira and foreign interest rates. If US interest rates rise, Turkish rates must rise as well, otherwise Turkish lira denominated assets will not be competitive. If simultaneously the country risk premium for Turkey also rises, interest rates in Turkey will have to rise even more. Otherwise capital will flow out, and the lira will depreciate further. Turkey cannot target its own domestic interest rate, its own exchange rate, and also allow free capital flows. The nation is not exempt from the Policy Trilemma.  However, the Prime Minister would serve Turkey better by trying to reduce the country risk premium rather than to raise it.

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