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Turkish Tailspin

After weeks of domestic turmoil, is Ankara losing control of the economy?


As the protests in Turkey enter their third week, Turkish Prime Minister Recep Tayyip Erdogan remains defiant, claiming during his weekly speech to the Justice and Development Party’s (AKP) parliamentary group meeting that law enforcement acted with "common sense" when it responded violently to anti-government protests and that he would "expand the powers of the police." The prime minister’s speech came just days after he dispatched riot police to clear demonstrators from Istanbul’s Gezi Park, sparking renewed clashes in cities across the country. The violence has since subsided and demonstrators have taken to standing silently in public to express their discontent, but weeks of unrest have taken their toll on Turkey’s financial markets and eroded investor confidence — an ominous sign for Erdogan, whose electoral success has depended in large part on the strength of the economy.

Erdogan and other senior members of the ruling Justice and Development Party (AKP) have blamed the protests on "foreign circles" uncomfortable with Turkey’s economic and political progress. The country’s economy minister, Zafer Caglayan, even went as far as accusing an international "interest rate lobby" of conspiring to seize $1.5 trillion from Turkey in the past 30 years. He was echoing previous statements by the powerful prime minister, who has paid special attention to Turkey’s own interest rate over the years. In particular, Erdogan has argued that the rate should remain close to zero in order to prevent the same "interest rate lobby" from taking advantage of Turkey.

It remains unclear who exactly is behind the prime minister’s nefarious — if non-existent — interest rate lobby, though one pro-government newspaper has identified it as a secret alliance between Jewish financiers, members of Opus Dei, and the Illuminati — all of whom are working together to tame Turkey’s impressive economic growth. More prosaically, Erdogan is probably referring to the chorus of investors, financial journalists, and other analysts who have called for Turkey’s benchmark interest rate to be raised to combat inflation. (The prime minister favors low benchmark interest rates in order to help stimulate the economy).  

Following the 2011 election, most observers expected Turkey to tighten its monetary policy so as to dampen inflation and slow its overheating economy. However, the independent Turkish Central Bank (TCMB) opted to cut the benchmark interest rate instead. It argued that following standard monetary policy and raising interest rates would attract more short-term portfolio funds — of the type Turkey relies on to finance its current account deficit, which as of April stood at roughly 6 percent of GDP — but also make the country more susceptible to external shocks, since these investments can move quickly out of markets.

The TCMB, therefore, opted to pursue a rather unorthodox strategy aimed at curbing the appreciation of the Lira and decreasing bank loans. The policy, known as an interest rate corridor, allows the government to vary its rates between the lower benchmark rate and the much higher overnight lending rate. In essence, the policy represents a compromise between the independent TCMB and Erdogan — which in turn raises questions about the prime minister’s influence in Turkish financial decision-making.

The policy has had mixed results. On the one hand, the economy slowed considerably, with GDP growth cooling from 8.8 percent in 2011 to 2.2 percent in 2012. On the other hand, private lending continued at a high pace, despite the TCMB’s higher overnight lending rates. The engineered slowdown did help narrow the current account deficit — driven to unsustainable levels by Turkey’s roaring GDP growth — and curb inflation, but worries about the country’s reliance on short-term financing persist. Going forward, there are signs that Turkey’s economic balancing act may be coming to an end.

Turkey’s perpetually high current-account deficit — which varies between 6 and 10 percent of GDP — is a long-term structural issue for the economy. In order to finance the current account deficit, Ankara relies on both foreign direct investment (FDI) and short-term portfolio flows. But Turkey’s long-term FDI has slowed, leaving the country at the mercy of portfolio flows and vulnerable to external shocks — whether it be independent actions by the U.S. Federal Reserve or the European Central Bank, or domestic political unrest. The bottom line is that Turkey’s dependence on speculative money — which goes out as easily as it comes in — puts the economy at risk.

In a worrying sign for the Turkish economy, money has recently begun to flee developing country markets for bonds in the United States. And while the retreat from investing in emerging markets began before the protests erupted in Turkey, the unrest has certainly called into question the country’s political stability and hastened the monetary retreat from Turkish markets.

The capital flight began in late May, after Federal Reserve Chairman Ben Bernanke telegraphed his intention to taper the $85 billion in bonds that the Fed is buying each month. If the Fed does decide to slow down its stimulus plan and U.S. bond yields continue to rise, countries with high-current-account deficits — like Turkey — are particularly vulnerable.

Also worrying for the Turkish economy is the poor performance of its currency. In May, the Lira hit its lowest value against the U.S. dollar in 17 months. The protests have exacerbated this downward trend and eventually forced Turkey’s central bank to intervene to prevent the Lira from depreciating further. On June 12, it auctioned off $250 million to Turkish banks to help prevent the further depreciation of the Lira. While the auction did manage to stabilize the currency, Turkey’s capacity to intervene further remains limited. One potential option to combat this weakness is to raise interest rates, but Erdogan has rema
ined steadfastly opposed to this option, maintaining that low interest rates are vital for Turkey’s economic success.

Despite these difficulties, the Turkish economy grew at an annualized rate of 3 percent for the first quarter of 2013, though this is well short of the country’s 4 percent growth target for the year. In reality, the economic picture is far more complicated than the economy minister — or Erdogan — would like Turkish voters to think. While blaming phantoms may appeal to some segments of the AKP’s base, it papers over the political and economic conundrum now facing Turkey’s leadership.

The protests have already dented Turkey’s tourism industry — a key source of revenue for financing the current account deficit — and the combination of a slumping EU economy and the various crises in Middle East has made it harder for Turkey to export its way out of economic malaise. Ankara will therefore have to rely on domestic demand to fuel economic growth, which will inevitably increase the country’s current account deficit — in turn making it even more vulnerable to the whims of the U.S. Federal Reserve. While Turkey’s economy is not going to collapse because the continued protests, the future is nonetheless gloomy. As a result, the AKP will most likely continue to focus on placing the blame elsewhere, rather than face the combined pressures of domestic unrest and central bank decisions abroad — both of which may have a profound impact on the Turkish economy going forward. While Erdogan has no influence on the Fed, he could opt to try and mimic the protesters and stay silent, in order to at least dampen the growing feeling in some financial circles that he has lost touch with reality.

Aaron Stein is a resident senior fellow at the Atlantic Council’s Rafik Hariri Center for the Middle East.

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