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Erdogan faces economic crossroads as inflation spikes

As Turkey's inflation hits its highest annual rate in 14 years, a small rate hike could be expected. But economic rationality and Erdogan’s politically coordinated cheap money boom have never been the best of bedfellows.

Annual headline inflation was nearly 13 percent in November, the statistical office said on Monday, up from 11.9 percent in October, above expectations and the highest since 2003, according to Turkstat.

While officials say inflation is expected to decline in 2018, most don't see it going south of 10 percent any time soon. Compared to inflation in the EU of around 2 percent, that is still very high.

To hike or not to hike?

So, the dilemma arises whether to raise interest rates, rein in inflation and bollster the ailing currency, the lira, but also by so doing limit the spread of cheap credit to those in Turkish society whom President Recep Tayyip Erdogan depends on most politically.

All eyes now point to the central bank's next regular monetary policy committee meeting on December 14 where it will decide on interest rates, on hold in recent months as inflation has crept upwards.

Erdogan is opposed to raising rates. The need to maintain a strong lira while keeping credit freely available has been a point of conflict between Erdogan and the central bank, which sees the abundance of credit and growing inflation as a threat to the lira's strength - and in turn Turkey's ability to service its foreign debt.

Analysts said they didn't expect a large hike of several hundred basis points unless renewed Turkish lira depreciation pressures force the bank's hand. The lira hit a record low of 3.97 against the dollar last month.

Erdogan delivers a speech at a rally a day after the referendum, in Ankara in April (picture-alliance/AP Images/Turkish Presidency)

Erdogan delivers a speech at a rally a day after the referendum, in Ankara in April

An aspiring middle class

But Erdogan's political survival depends to a large extent on meeting the aspirations of the growing Turkish middle class and his cheap credit policies were designed specifically for them.

Whenever confronted by economic problems, Erdogan has waved the flag and pointed to the threat posed by terrorism and 'dark operations' trying to bring down the country.

While this has largely worked in recent years on the back of strong economic growth, this is also historically a group whose political investment in the Erdogan regime is strongly correlated with the economic payoffs, and certainly the non-erosion of savings that inflation necessarily entails.

While GDP grew 5.1 percent in the second quarter, in part thanks to strong exports, the Turkish lira has fallen against the US dollar by 13.5 percent since September, making exports cheaper, but also in turn imports dearer, thus also stoking inflation.

Turks have seen the steady decline in value of the Turkish lira against the dollar (Getty Images/AFP/O. Kose)

Turks have seen the steady decline in value of the Turkish lira against the dollar

Debt: kicking problems down the road

Turkey's ratio of gross external debt to GDP has jumped from 39 percent in 2012 to 52 percent. Erdogan wants to increase available credit to keep spurring economic activity, but there is not enough domestic capital to meet Ankara's lending needs.

The solution has been external borrowing, thus bringing in exchange rate risk.

While households are not allowed to take out consumer credits denominated in foreign currency, financial institutions borrow in foreign currency - mainly US dollars and euros - and banks extend credit domestically in lira.

Credit payment defaults by Turkey - the 17th-largest economy in the world - would have a big impact on lenders but also on Erdogan's position.

The yield on Turkey's two-year lira notes rose 17 basis points to 13.21 percent in October, its highest since April 2009, and have edged up this week again. That means barely positive real yields, something that is painfully clear when volatility hits — and in Turkey that could be any time. 

One significant possible outcome could be Ankara losing its ability to maintain a military deployment in Syria and without a Turkish presence in western Syria, Iran - Turkey's traditional rival - would have a freer hand to influence areas farther west in Syria.

US-based cleric Fethullah Gulen, whose followers Turkey blames for the failed 2016 coup (Reuters/G. Savoy)

US-based cleric Fethullah Gulen, whose followers Turkey blames for the failed 2016 coup

Corruption cherry on the cake

Erdogan's problems are compounded by revelations coming from the trial in New York of a Turkish banker accused of violating US sanctions against Iran.

Since the trial started last week the lira has traded at 3.90 to the US dollar, down about 2 percent. 

Reza Zarrab has implicated Erdogan in a scheme allegedly designed to subvert Iranian sanctions and admitted to bribing a former Turkish economy minister, Zafer Caglayan.

Zarrab said he had learned from Caglayan that Erdogan and then-treasury minister Ali Babacan had authorized two Turkish banks, Ziraat Bank and VakifBank, to move funds to Iran.

Zarrab claims to have paid approximately $70 million (€59 million) in bribes to Caglayan.

The Turkish government claims that everyone involved in the trial are Gulenists - followers of Fethullah Gulen who they accuse of plotting last year's coup attempt.

But in the absence of an independent judiciary after last year's coup attempt and this year's constitutional referendum, and getting to the truth about Gulen's role - if any - the extent of Erdogan's corruption are both unlikely.

On a range of issues - from Turkey's purchase of Russia's S-400 missile system to the Zarrab trial - a focus on Erdogan's finances as much as his politics is clearly needed.

Azerbaijani businessman Reza Zarrab surrounded by journalists in Istanbul in 2013 (Getty Images/AFPO. Kose)

Azerbaijani businessman Reza Zarrab surrounded by journalists in Istanbul in 2013

jbh (AFP, dpa)

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