Turkey's serious inflation problem

Turkey is now stretching the limit of acceptable rates of inflation for a responsible, emerging-market economy.

Headline consumer prices surged to 11.9 percent last month, exceeding all analyst expectations, the highest level since 2008. The rate exceeds average BRIC inflation more than four-fold. Price increases in Brazil, Russia, India and China, are at 2.6 percent.

President Recep Tayyip Erdoğan’s stimulus to the economy and a compliant central bank means Turkey now finds itself alone in terms of inflation, sandwiched between the established emerging markets, which also include countries such as Poland and South Africa, and more “basket-case” economies, such as Ukraine and Argentina.

Emerging-market inflation

In stark contrast to Turkey, price increases are slowing in most other markets. Inflation in Russia, so often an alternative destination to Turkey for foreign investment, has more than halved over the past year to 3 percent. In Brazil, the rate has dropped by more than two-thirds in a year to 2.5 percent. Indian and Chinese inflation is in decline, while Hungary’s fell to 2.5 percent in September.

Normally, higher rates for actual or targeted inflation are accepted by investors who are buying assets in emerging markets. These economies are able to absorb faster price increases because growth rates are so high. For instance, South Africa has an inflation target of 4.5 percent while its economy is growing at a quarterly 2.5 percent. India set its goal at 4 percent last August. Its economy is expanding at 5.7 percent.

But when investing in such countries, investors rely on confidence; in other words expectation that the monetary authorities and the government will maintain economic growth while broadly adhering to inflation goals and implementing prudent economic and fiscal policy.

Turkey is slipping in this regard.

In the 1990s, successive governments failed to tackle a serious inflation problem that became critical and finally sent the economy into crisis in 2001. After Erdoğan won elections the following year, Turkey achieved single-digit inflation for the first time in decades, thanks to an IMF-backed programme that overhauled the economy and democratic reforms that won Turkey membership talks with the European Union.

In 2005, the government introduced the new Turkish lira to much fanfare, exchanging 1,000,000 old lira for 1 new.

Inflation since Erdogan
Inflation in Erdogan era

To help draw in foreign capital, Turkey had followed a strict system of inflation targeting from 2006 to 2008 and a more flexible regime thereafter, with a goal of 5 percent, as the central bank switched to a wider remit of ensuring economic growth, post-September 11th, while maintaining price stability. It has managed to bring down the rate to the target just once, in 2011.

But what is now startling, and most concerning, is the divergence between actual and targeted inflation. Though former Central Bank Governor Erdem Başcı missed Turkey’s 5 percent goal for five years in succession between 2011 and 2015, average inflation was 7.6 percent. In 2017, inflation has been in double figures since February, save for a dip to 9.8 percent in March.

Inflation this year
Inflation this year

At the heart of the problem is politics. Turkey’s central bank is probably under more pressure than any counterpart in major emerging markets to support government stimulus, rather than tame inflation. As discussed in my article on Oct. 27, Governor Murat Çetinkaya is dealing with a president who believes interest rates cause inflation, and who is demanding lower borrowing costs. And the government, which stimulated the economy with over 200 billion lira ($51 billion) in loan guarantees this year, is running out of options to boost economic growth. The last thing it wants is interest-rate action by the central bank.

Çetinkaya, a former Islamic banker hand-picked by Erdoğan, has kept the benchmark one-week repo rate unchanged at 8 percent since last November, when he raised it by just 0.5 percent to help arrest a slide in the lira.

Since then, he has focused on the late liquidity window rather than the benchmark; increasing the rate there to 12.25 percent in three successive months ending in April.

As Uğur Gürses, a leading columnist on the economy in Turkey, said in Hürriyet newspaper on Nov. 2:

Just imagine you are looking at Turkey from outside. When a central bank with a 5 percent inflation target indicates that it will not meet the goal for more than two years, you would read it as it saying: “I have no intention to keep to my target".

Servet Yıldırım, a columnist for Milliyet newspaper, said this week that market expectations for inflation were worsening and that it may take some time for the central bank to repair the situation, should the trend continue.

But raising interest rates, even for the late liquidity window (where banks have been forced to borrow more this year), would run contrary to Erdoğan’s wishes.

In the meantime, lira depreciation – the currency has lost 8.5 percent over the past month – means inflation will accelerate before it slows, as currency weakness translates into higher prices for imported goods.

Impending rate hikes by the Federal Reserve, already impacting emerging market currencies and bonds, will not go away. And nor, perhaps, will efforts by Erdoğan to stimulate the economy – there is already talk of the government extending credit guarantees for several more months, perhaps with funds from its controversial Sovereign Wealth Fund.

Hence, Turkey’s inflation problem, which is becoming more serious by the day. With no action by the central bank on the horizon, save for a few tweaks here and there, it will take another big hit to the lira to force it into any sort of serious move. And even that may not be enough.