Erdogan must be feeling pretty invincible right now, after winning yet another election. However, he won’t be for long because he’s really pushed Turkey’s economy to the brink to pull off this win. So now, as the Lira nosedives and his unorthodox mix of solutions is starting to crumble, the Turkish economy is rapidly nearing its breaking point.

Just to illustrate how little time the country has left, the Financial Times has reported that in the 6 weeks leading up to the first election round, Turkey’s central bank lost roughly 15% of its foreign currency reserves in an effort to prevent the Lira from falling faster than it already did. So, market participants are now increasingly betting on an immanent default of the Turkish government. This means that Turkey could soon join countries like Lebanon, Sri-Lanka, and Argentina to become the latest economic basket case.

But, why now? Why is Turkey’s economy now reaching a breaking point after it held out so much longer than many analysts predicted? And, is there any way it can still be saved?

To answer these questions, let’s first do a quick recap of two big problems that have been plaguing the Turkish economy.

Quick recap

For years now, while the Turkish economy grew at an impressive pace, it’s currency the Lira kept falling, contributing to sky high inflation in Turkey as imports kept getting more expensive. Luckily, economists and the Turkish government largely agreed on the two big problems leading to the Lira’s rapid decline.

We’ll dive into those two details after I tell you all about the sponsor of today’s video: The Daily Upside.  As anyone who spends time-consuming financial content is well aware — finding relatively unbiased and insightful sources is an incredibly challenging task. Some might even say it’s futile.

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Now, let’s get back to the two big problems that have led to the Lira’s rapid decline.

Quick Recap.

The first problem was a massive trade deficit, meaning that for years Turks have been importing more than they export. This has consistently put pressure on the Turkish Lira. After all, to buy foreign goods, you need foreign currency. And so, on average for import focused Turkey, there was a lot more demand for foreign currency than for the Turkish Lira.

The second problem was rapid Dollarization, meaning that in essence a small Dollar based economy grew inside Turkey that was getting bigger and bigger as Turks increasingly felt that their own currency was loosing its value too fast. Ironically, this made the Lira fall even more as Turks increasingly sold their Liras so that they could save in Dollars, Euro’s or Gold.

But, while economists and the Turkish government basically agreed on these two problems, they didn’t agree on a solution.

You see, the standard way that economists recommend you deal with a currency that is falling too fast, is to raise interest rates. This will simultaneously discourage banks from lending into an economy that is running hot, decreasing inflation, and it will also make the currency more attractive for both foreign investors as well as local Turks by offering a higher return.

However, Turkey’s president Erdogan, famously hates high interest rates, be it for religious reasons, saying stuff like this at his rallies

They have Dollars. We have Allah.

or, some say that he believes in a highly unorthodox economic theory that predicts that high interest rates actually cause high inflation.

Whichever it is, he often ordered the central bank to lower interest rates precisely when standard economic would advice that you raise them. And this is why economists have long been predicting the collapse of the Lira. However, as I discussed on this channel at the end of 2022, this didn’t lead to the collapse of the Lira at the time because Erdogan’s government was tackling the Lira’s fall using some

Highly unorthodox solutions

First, Turkey’s central sold a lot of its foreign exchange reserves to prop up the Lira. And then, when it basically ran out, it convinced former geopolitical rivals in the area to lend it foreign exchange reserves in exchange for political favors, so that it could keep propping up the Lira.

Second, to counter Dollarization, it started it’s so called Lirarization strategy. In effect, this meant that Turks which had foreign currency could open a special deposit account for which the government would compensate it with more Lira’s if the Lira fell so much that the owner would have been better off with Dollars.

And actually, this worked for a while, halting Dollarization, stabilizing the Lira and this gave the Turkish government some time to tackle its other big problem, it’s trade deficit.

However, despite some successes like opening a massive new Gas field in the Black Sea, Turkey’s trade deficit got wider than ever before. The most likely explanation for this is that throughout 2023 Erdogan encouraged the Turkish banks to extend more and more credit, this new money in Turkish hands was partially spent buying more stuff in Turkey, increasing inflation, and buying more stuff from outside of Turkey.

And so, after some relative stability, the Lira continued its fall, and now means that

Turkey’s Economy is nearing a breaking point

You see, the fall of the Lira is now undermining both of Erdogan’s unorthodox solutions.

First, while the Gulf states have been willing to support the Lira in exchange for political influence, its continued slide is making it riskier and riskier for them to keep lending Dollars to Turkey because of the decreased chance that Turkey can pay them back. And, as we have seen with Pakistan recently, while Gulf states have deep pockets, they are not prepared to back countries indefinitely.

Second, while Erdogan’s Lira deposit scheme was a big success, it was also risky. You see, if it worked in stabilizing the Lira, it wouldn’t cost the Turkish government anything. After all, they only need to pay out extra compensation if the Lira loses value. But, now as the Lira keeps sliding, the Turkish state will have to pay these deposit holders a lot of extra Liras. Which it could be forced to start printing, which would further devalue the currency, and so on.

In other words, Erdogan’s innovative but risky Lirarization strategy could now lead to a doom-loop of paying deposit holders with newly printed currency, which devalues the Lira and so on.

But, will it? Or

Can Erdogan Save The Lira Once More?

Well, that is highly uncertain. So, as I often do on this channel, I shall present you with three scenario’s and give them a likelihood.

The first scenario is another Turkish miracle. In this scenario, the Turkish government convinces Arab backers to give them more money. At the same time, having won the election, the newly elected government now takes steps to cool down bank lending in the country, which combined with rising gas production reduces domestic inflation and turns Turkey’s trade deficit into a surplus. This will eventually halt the fall of the Lira and increase the chances that it’s Lirarization policy is a success.

Sadly, I don’t think this scenario is very likely and give it a 15% likelihood since the Turkish central bank is running out of reserves too fast. Just to get an idea of how fast, while Turkey secured almost 20 billion Dollar loans from Arab states last year, it just burned through $17bn in reserves in the 6 weeks just before the first election round.

The next two scenarios are breaking point scenarios. However, they play out very differently.

In the second scenario, Erdogan once again surprises friend and foe and returns to economic orthodoxy.

In this scenario the central bank will raise interest rates, and the government will get an IMF loan. To appease them, however, it will introduce austerity policies. This will lead to a painful economic recession, which will eventually stop the fall of the Lira. Therefore, in this scenario the Lira will eventually stabilize.

However, because Erdogan remains in power, I think this scenario is also rather unlikely and give it a likelihood of 10%

This brings us to the final scenario. In this scenario, the Turkish government refuses to raise rates, or keeps them as is, while it keeps stimulating the local economy in an effort to keep the people happy. However, seeing a sinking ship, the Arab backers are no longer willing to lend the Turkish central bank the reserves it needs to defend the Lira. As a consequence, the Lira crashes and Turkey’s economy either completely collapses in a Lebanon style hyperinflation scenario or it will for decades be plagued by cycles of sky-high inflation and default, much like Argentina.

Given that Erdogan just won the election, and has shown to be fairly stubborn, I think this is now the most likely scenario and will give it a likelihood of 45%.

However, as you might have noticed, these probabilities do not add up to 100%. This is because, of course, there are many other combinations possible. Macroeconomic developments are notoriously difficult to predict because they depend on complex interactions between politicians, natural events, and markets. Perhaps the IMF judges that Turkey is too important and accepts some more unorthodox policies than they usually would.

But, the main reason that I think 30% uncertainty is warranted in this case is because Erdogan’s government has shown itself aware of the main problems and rather creative in their approach to solve them.

But, hey that is my take. Have I been too cautious? What probabilities would you assign these scenarios? Let me know in the comments, or in more detail on the Money & Macro Discord server for Patrons and members. And, if you want a more in-depth look at Turkey’s economic problem, check out my previous videos on the subject here, or alternatively this video that YouTube thinks you will love over here.