How Erdogan’s Unorthodox Views Are Rattling Turkey’s Markets

Turkish President Recep Tayyip Erdogan isn’t the only politician who doesn’t like it when the country’s banks charge people relatively much to borrow money. What sets him apart is his unorthodox belief in low interest rates and determination to take central bankers out of control of monetary policy. The result: a succession of cuts in benchmark rates that have fueled runaway inflation and caused a currency collapse.

1. What is Erdogan’s advantage with high interest rates?

He says they are slowing economic growth and fueling inflation. The dissertation has been a concern for international investors for years. While the country’s spending and credit crunch propelled growth during the pandemic, the economy has also suffered from double-digit inflation and unpredictable policy moves. He has also referred to Islamic prohibitions on usury as the basis for his policy.

2. Are his arguments reasonable?

The point about weaker growth is. When a central bank raises rates, banks are less able to borrow to hold mandatory reserves and tend to lend at their own increased rates. This makes loans for businesses rarer and more expensive and can therefore slow the economy. But Erdogan’s second idea – that high interest rates drive prices up – contradicts conventional economic theories.

3. What is the basis of Erdogan’s theory?

It is likely based in part on his experience running businesses, especially in the food industry, before his career as a politician took off. Many Turkish companies borrow relatively much to cover operating costs, making the volatility of borrowing costs a source of uncertainty and interest rate hikes an additional cost. According to Erdogan, higher tariffs lead to higher prices because companies have to pass higher costs on to their customers. This makes assumptions that orthodox economists dispute, namely that interest rates make up a significant portion of firms’ costs and that producers have sufficient price power to impose their will on consumers.

4. Who agrees with Erdogan?

The argument is based on a theory by Yale University economist Irving Fisher about the relationship between inflation, nominal interest rates, and real interest rates. Critics of the neo-fishermen say that even if their theory were valid, it would not apply to an economy like Turkey’s, which suffers from chronically high inflation and relies on foreign financing. That’s because lowering interest rates lowers returns on investments in Turkish assets, and the local currency tends to weaken when foreigners decide to invest their money elsewhere. That increases the cost of imported goods in liras and results in higher prices, or more inflation.

5. What has Erdogan done to put his views into action?

Many central banks have increased borrowing costs to fight inflation after the pandemic. Turkey has gone the other way, cutting its benchmark rate by 7 percentage points to 12% in the 13 months to September. During that period, the lira gradually weakened and inflation accelerated. The government raised the national minimum wage in December and July to limit the blow to households. This pushed prices further, pushing inflation to a 24-year high of over 80% in August – the fourth highest of 120 countries tracked by Bloomberg. Erdogan stood his ground, saying that what Turkey needs is more investment, production and exports, not higher interest rates.

6. What is the impact on the financial markets?

Interest rates on commercial debt began to diverge from benchmark rates as lenders hesitated to offer increasingly cheaper loans when the central bank’s supply of short-term financing wavered. In response, monetary authorities imposed rules to force banks to bring their lending rates closer to the benchmark. They were also required to increase their holdings of lira-denominated, fixed-income government debt. As a result, the cost of lira debt fell, while yields on junk-rated Turkish dollar bonds went in the opposite direction.

7. What is it doing to the economy?

Homes, cars and many essential goods became unaffordable for some of Turkey’s 84 million inhabitants. Food inflation hit the low earners, while the middle class saw living standards under pressure. On the other hand, economic growth outperformed Turkey and unemployment was relatively low due to an abundance of cheap labour. As the stock market rebounded and kept pace with inflation, bond investors struggled to adjust to a world of 68% real negative returns. The lira hit an all-time low against the dollar in September, although the central bank has spent an estimated $75 billion this year to support the currency, according to calculations by Bloomberg Economics.

8. Can Erdogan change course?

Erdogan has indicated that he will do everything he can to keep his low interest rate policy intact. Finance Minister Nureddin Nebati told investors frustrated by low bond yields that they can find good returns in Turkish stocks. With elections approaching in 2023, Erdogan is wary of changing course and risking borrowing rates skyrocketing, which could hurt consumers even more. To bolster popular support, he announced a $50 billion project to increase homeownership, introduced a rent cap, cut some student loans and promised another big raise in the minimum wage. He is aware that the economy is his biggest challenge, and economists are not ruling out a policy rethink after the election.

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