Lowering interest rates with 'sharp ideas' cost a lot

PROF. BULENT GULTEKIN,

Former Central Bank Governor and Former President of the European Finance Association (EFA), now a Professor in the Finance Department at the Wharton School of the University of Pennsylvania.

YOU RESIGNED FROM THE CENTRAL BANK ˷CB˸ GOVERNORSHIP WHEN THE 1994 ECONOMIC CRISIS STARTED. WHAT STEPS HAS THE GOV˹ ERNMENT TAKEN SINCE THEN?

We didn’t learn a lesson from the 1994 crisis. The coalition government signed the 18th Stand-by agreement with the International Monetary Fund (IMF) in December 1999. The IMF imposed a wrongfully designed program that didn’t, theoretically, have an exit strategy. The program, which used foreign exchange (FX) rates as the nominal anchor, collapsed in February 2001. The cost of the 2001 economic crisis, which started as an FX crisis and transformed into a banking crisis, was heavier than the 1994 crisis as budget deficits funded by external debt and irresponsible actions of banks grew to a larger scale.

Kemal Dervis, Former Economic Affairs Minister, started to implement the IMF’s economic program backed by the World Bank – the ‘Strong Economic Program’. The government nationalized all private loans of bankrupted banks that came from abroad. The Treasury couldn’t restructure domestic and external debts. The political result of the program was that the coalition partners were erased from politics and the AK Party came into power.

The AK Party government continued to implement the IMF’s program following a few months of hesitation. The program reduced external debt. Investments and productivity increased until 2004 as a result of the European Union (EU)-Turkey Customs Union (CU). Thanks to the CU, the Turkish industry saw new opportunities, competed with the world, and made investments in productivity increase. Turkish brands made their mark in the EU market for the first time in that period.

Turkey was on international investors’ radars after it started negotiations with the EU for full membership in 2005. Opportunities provided by privatization revenues and foreign capital inflows paved the way for the AK Party to act as a comprehensive social state. But it neglected two important strategies in this period. First, it allowed TRY to appreciate significantly after the 2001 crisis. TRY appreciated by two from 2001-2008. Second, it neglected policies to save Turkey from the middle-income trap, longterm projects to develop human capital. This prevented Turkey from having quality growth. A similar situation before the 1994 and 2001 crises emerged following an overvalued TRY, a decline in foreign direct investments (FDI), and privatization revenues. Savings decreased compared to the national income. The economy started to grow as a result of domestic demand backed by relatively cheap imports and consumption loans. The AK Party started to falter and economic growth started to slow following the 2008 U.S. financial crisis.

TRY has continuously devaluated in real terms and inflation has risen since 2010. Turkey has entered a gradual inflation-FX rate cycle following the Presidential system. The average annual economic growth was 4.8% between 1924-2020. It stood at 4.4% between 2002-2020, when the AK Party was in power. This isn’t a successful score.

THE GOVERNMENT EMPLOYS THE ECONOMIC APPROACH THAT ‘INTEREST RATES CAUSE IN˹ FLATION.’ HOW DO YOU EVALUATE THIS?

Nominal interest rates consist of three components in an open economy: natural rate of interest + inflation forecasts + country risk premium (CRP). The natural rate of interest is steady despite differences among the countries. The inflation forecast is a result of the the country’s macro balances. The CRP is relevant to the country’s political and economic stability. Interest rates can be reduced by decreasing inflation forecasts and the CRP. Transparent and effective economic policies will reduce the CRP. High inflation points out serious instabilities in the economy. Inflation can be controlled only with growth that takes into account macro balances. Reducing high inflation is a hard and painful process that can’t be done quickly or unilaterally. It requires a set of serious economic measures. The president’s opinion that interest rates cause inflation, which caused FX rates to reach the current levels, doesn’t have an economic basis.

THE GOVERNMENT HAS IMPLEMENTED THE FX˹ PROTECTED TRY DEPOSIT ACCOUNT AFTER USD/TRY AND EUR/TRY EXCEEDED 19.00 AND 20.00, RESPECTIVELY. WHAT DO YOU THINK ABOUT THIS?

The FX-protected TRY deposit account (KKM) gives an unsecured option to deposit accounts that relies on FX rate movements.

Another important fact is that the Turkish banking system already creates FX deposit accounts alongside TRY deposit accounts. Two currencies circulate at the same time in Turkey, in a sense. This complicates the monetary policy. I don’t think that a new FX-indexed instrument will facilitate the monetary policy.

THE GOVERNMENT HAS REDUCED THE INTEREST RATE, WHILE THEY HAVE ATTEMPTED TO STOP THE FX RATE HIKE WITH FX SALES AND THE CB’S RESERVES HAVE DECLINED DURING THE PANDEMIC. HOW DO YOU INTERPRET THIS PERIOD?

Serious mistakes have been made in this period and these mistakes continue. There is a rule in macroeconomics that is called ‘the impossible trinity’. Free capital movement, a fixed FX rate, and an independent monetary policy can’t be conducted at the same time. If interest rates and FX rates are to be controlled at the same time, the capital should be controlled. If interest rates are to be reduced in a free capital regime, FX rates can’t be controlled. If negative real interest rates are aimed, the FX-rate-inflation spiral will begin. Intervention with the sales of reserves will be effective on FX rates for a while, but the CB’s reserves will start to decrease after a while and the outflow from TRY will accelerate. Moreover, if FX cash outflow starts in the banking system, as happened in the 1994 and 2001 crises, the possibility for this to transform into a banking crisis will increase. A possible crisis was prevented when the interest rate was raised from 8% to 17.75% in June 2018.

“Turkey should resolve economic and structural problems in order to attract FDI. Expecting longterm FDIs in a country whose future has been dragged into deep uncertainty with poor economic policies is overoptimistic.”