Following years of uninterrupted growth during which the country was hailed as a success story for emerging markets, the Turkish economy has started to show signs of overheating in the aftermath of the coup attempt in 2016. The impact of the coup attempt was multifaceted: The state of emergency that had to be imposed in its aftermath initially created unfounded concerns for international investors concerning the continuation of the rule of law, declining domestic demand had to be supported with massive public stimulation packages through the Credit Guarantee Fund and worsening relations with the U.S. due to the perpetrators of the coup created an additional risk factor through the foreign policy channel. The critical period between 2016 and 2018 witnessed crucial developments in Turkey such as successive elections, transition to the presidential system and geostrategic rapprochement with Russia, including the purchase of S-400 missile defense systems, while the global conjuncture for emerging markets continued to deteriorate in the wake of impending currency and trade wars.
The juxtaposition of critical political and geostrategic processes has delayed a necessary cooling-off or soft landing that was desperately needed in the Turkish economy following the post-coup fiscal expansion. The conventional growth-orientation that underlined the successful political performance of the Justice and Development Party (AK Party) administrations continued to underline the broader contours of macroeconomic management. But after high growth figures following the coup attempt in 2016, the influx of both portfolio and foreign direct investment resources became a problematic issue as international investors preferred to go back to the safety of the booming U.S. market. While the contraction of international liquidity constituted a source of pressure for both growth momentum and the value of the Turkish lira, which lost around 40 percent of its value against the U.S. dollar, the situation was exacerbated by a series of diplomatic and trade disputes experienced with Washington D.C.
In recent months, the devaluation of the lira started to have a serious impact on price stability through the cost channel as most productive sectors and exporters are dependent on imports, and highly sensitive to rises in the exchange rate. Over the course of Turkey's political and economic history, high inflation associated with low economic growth have always been perceived negatively by the wider electorate; therefore, policy makers could never turn a blind eye to the uncontrolled rise of inflationary pressures.
Indeed, the Central Bank of Turkey announced a whopping 625 basis points rate hike on Thursday, increasing the benchmark interest rate from 17.75 percent to 24 percent. This radical rate hike was much higher than the expectations of most pro-market observers and could be perceived as a definitive step to end futile discussions surrounding central bank independence. It is no secret that President Erdoğan favors a pro-growth strategy in macroeconomic management that is based upon lowering interest rate figures to allow the flourishing of both domestic consumption as well as small and medium-sized enterprises across the country. This approach has a sound political economy basis as entrepreneurs and owners of small and medium-sized enterprises across Anatolia constitute the backbone of the AK Party, and measures that would influence them negatively are bound to have political ramifications. Radical interest rate hikes also tend to curb domestic consumption and force consumers to delay their purchasing decisions, which also affects the psyche of the electorate negatively.
But both Erdoğan and the wider economic management team have transcended narrow political calculations and focused on long-term price and financial stability, as demonstrated by the latest decision of the Turkish central bank. The anti-inflationary stance that will be adopted in the coming months will most probably include a tight fiscal and monetary policy that will cause substantial cuts in public expenditure, increases in certain taxes, interest rate hikes and rationalization of public investments. To use academic jargon, we might argue that Turkey has entered a process of economic balancing through conventional policies assuming moderate growth and a comprehensive anti-inflationary program.
This period of balancing over the course of 2019 and 2020 shall also be supported via strong fiscal tightening in the context of the Medium-Term Program. Turkey could revamp its growth model towards domestic savings, effective local production networks and robust export capacity if this period of balancing is managed smoothly. Stabilization and structural transformation will have to proceed simultaneously for a brighter future, and Turkey has the necessary capacity to achieve both.