Home ›› 03 Mar 2022 ›› Opinion
Inflation is the macroeconomic mot du jour. In the wake of Covid-19, an unexpectedly sharp rebound in aggregate demand has led to supply chain disruptions, energy shortages, and overheating from fiscal stimuli. As if that weren’t enough, the war in Ukraine has also brought back the ghost of the 1973 oil price shock, with Brent crude surging past $105 a barrel on the 24th of February before declining moderately. Annualised retail inflation in the United States has touched 7.04 per cent. The figures elsewhere are equally sobering: 5.1 per cent in the Euro Area, 10.38 per cent in Brazil, and 6.01 per cent in India.
Yet Turkey’s unique predicament stands out above all others. As inflation (annualised) reached an eye-watering 48.7 per cent in January, the spectre of hyperinflation looms over this once-dynamic emerging market. Last year, the lira lost 44 per cent of its value against the US dollar, in which most of its sovereign debt is denominated. Despite a 50 per cent increase in the minimum wage, January data shows that the consumer price inflation rate has now wiped out most of the pay rise. Prices of potatoes, onions, brinjals, green beans, and other vegetables have soared to 150 per cent of their levels last year.
Food inflation in Turkey (latest figures)
How did the conversation about Turkey of all places move into the dismal territory of hyperinflation, dollarisation, currency crash, and capital flight? What is the future of Turkey’s credit-fuelled construction sector? With Turkey’s runaway inflation nipping at the heels of Argentina’s 50.9 per cent, is it doomed to similar lost decades?
Or worse, will Turkey soon meet Phillip Cagan’s now-consensus definition of hyperinflation, with prices rising more than 50 per cent per month for an extended period? While it is still in the realm of nightmares and is eminently avoidable, if hyperinflationary dynamics take hold, the Turkish economy could collapse- like Venezuela’s. In a region that only recently weathered the mother of all refugee crises in 2015, and now the Ukrainian refugee crisis, what might that mean in terms of a similar exodus of people from Turkey? This one, however, would be driven by economic collapse instead of war, and thus much more politically vexed.
The proximate cause of these troubles is a deeply unorthodox monetary policy experiment which President Recep Tayyip Erdoğan is committed to, sacking three central bank governors who did not fall in line. The reasoning underlying this experiment follows from the work of Irving Fisher, one of the earliest American neoclassical economists. Fisher claimed that when inflation rates are too low, central banks should raise their targets for nominal interest rates. This positive correlation between nominal interest rates and inflation is empirically observable and is called the Fisher effect.
Turkey is the first country to put this theory to the test in real time. However, there is a catch: modern macroeconomics interprets the direction of causality going from inflation to nominal rates, while Erdogan and his officials have bet on the opposite, in attempt to reduce inflation via cuts to the nominal interest rate. The problem? As with all neoclassical assumptions, monetary neutrality only holds in the very long run, in which, as Keynes quipped, we are all dead. A drop in the nominal interest rate decreases the real interest rate, hurting both domestic and foreign savers, who now have negative returns. A negative real interest rate (on its way to -16 per cent!) also makes it harder to sustain Ankara’s hitherto deficit-financed growth strategy.
In a frantic effort to shore up domestic savings, Turkish authorities announced that if the lira’s decline against benchmarked currencies exceeds banks’ short-term deposit rates, the government will pay holders of lira deposits the difference. While the results of such rearguard efforts remain to be seen, it does precious little to change the minds of foreign savers, with capital outflow seeming more and more tempting each day. As mentioned above, Turkish growth is debt-financed, which means that capital flows are a more important determinant of short-term domestic lending rates than rates set by the central bank. This is called the ‘short rate disconnect’ in economics literature, and is observed when domestic banks depend on foreign capital inflow to fund their operations. Once they are adjusted for depreciation, there should be no difference between lira deposit rates and dollar deposit rates.
As Şebnem Kalemli Özcan puts it, “If foreign institutions lend in lira, they charge a risk premium, which now has increased, owing to massive exchange-rate depreciation. And if they lend in dollars, they charge a premium for default risk, which also has grown. The recent record-high Turkish credit-default swap spreads are a good example of this. As foreign investors abandon Turkish markets – or charge higher risk premiums to stay – both currency depreciation and inflation will increase.” Sure enough, the Turkish 5-year CDS value (as on the 21st of February) is 593.6, which reveals a 9.89 per cent implied probability of default, on a supposed 40 per cent recovery rate.
One way to solve the problem of persistent price and currency instability is through dollarisation. Zimbabwe dollarised between 2015-19 following years of hyperinflation, which immediately reduced inflation and opened up space for long-term economic planning by bringing in much-needed foreign investment. The spectre of dollarisation, however, should concern the nationalist government of AKP: besides being a dampener on export competitiveness and disadvantaging trade with local partners, dollarisation would mean a considerable loss of sovereignty to the United States. Turkey under Erdoğan has been doing its utmost to diversify its geopolitical options, and dollarisation could undo years of effort.
For their own part, the people of Turkey can try to spend their paycheques immediately instead of letting inflation eat away at their purchasing power. If things get desperate, taking loans at rates below inflation might also make sense, because the debt is reduced by rising price levels. Labour unions can try and negotiate pay raises above the rate of inflation, although policymakers must ensure this does not cross a certain threshold and unleash a damaging wage-price spiral. Converting lira savings into dollars or cryptocurrencies and buying inflation-linked bonds or tangible goods such as real estate are also worthwhile. But with the world’s fourth highest number of youth not in employment, education, or training (22 per cent) as per the OECD, Turkey’s high inflation levels add to the overall misery index. This could have potentially disastrous socio-political consequences.
Turkey could also try doing what Brazil did in the 1990s to curb hyperinflationary dynamics and return to macroeconomic stability: refinancing external debt through negotiations, indexation to virtual currencies like the Unidade Real de Valor (URV), and finally, the introduction of a new currency, like Brazil did with the real in July 1994. One real was set as equal to one URV, and the June 1994 inflation rate of 47.43 per cent sank to a much more tolerable 6.84 per cent by the end of July. Annualised, inflation in Brazil fell from 2477.15 per cent in 1993 to 916.43 per cent in 1994 to 22.41 per cent in 1995. Above all, Brazil committed itself to the macroeconomic tripod: maintenance of primary surplus, flexible/fluctuating exchange rates, and strict inflation targeting.
What will not work, however, is an elected strongman waging a quixotic ‘economic war of independence’ and calling interest rates, inflation, and exchange rates ‘the devil’s triangle.’ Erdoğan might well be surprised by how little store investors and global markets set by neo-Ottoman piety. But it is his hapless citizenry, after all is said and done, that will ultimately have to foot the bill.
The writer is a research associate at the South Asia Institute of Research and Development, Kathmandu, Nepal, writing exclusively for The Business Post. He can be contacted at sahasranshu.dash@gmail.com
