Will Turkey's boom bust?

Turkish Prime Minister Recep Tayyip Erdogan is at loggerheads with the country's central bank over monetary policy - a conflict that could have profound consequences for the future of the Turkish economy.

Erdogan wants the central bank's core interest rate, adjusted for inflation, kept near zero to encourage maximum lending - but the central bank, worried about inflation risks and currency depreciation, wants to increase the interest rate.

For now, Erdogan is winning. The Turkish central bank, or CBRT, lowered its headline interest rate for the third month in a row in July. But critics say Erdogan's policy victory will eventually result in a major financial crisis in Turkey, if and when the country's massive private-sector debt bubble, fuelled by excessively cheap credit, stops growing.

In January, the CBRT had raised interest rates sharply in a bid to curb Turkey's current account deficit, stop a dangerous decline in the currency's exchange value, and slow an exodus of international 'hot money' set off by US monetary policy changes.

It has since come under strong pressure from Erdogan's government to bring interest rates back down - and the government's success in getting the central bank to do so has forced investors to recognize that the CBRT's monetary policy committee is only nominally independent of the government.

Stimulus and sharia combine to hold Turkish interest rates low

Erdogan's low interest rate policy is driven by a desire to stimulate lending and hence consumer and business spending. It's also inspired by an Islamic prohibition against 'usury', or lending money at interest.

Erdogan believes that if the central bank keeps the effective interest rate - the nominal interest rate less the inflation rate - at zero, Turkey would do justice to the Sharia law prohibition against usury.

“We aim to cut the real interest rate in the long run, so people will increase their incomes through working, not through interest,” Erdogan said in May 2011 to the Islamic business association Tuskon in Istanbul.

“Eventually we aim to equalize the interest rate and inflation rate.”

Erdogan is a leading contender to win the post of President of Turkey in elections on August 10. He says that if he wins, the same economic policies will continue to be applied that have been in effect since he took office as Prime Minister in 2003.

During that period, Turkey's GDP has nearly quadrupled. Major public infrastructure investments - bridges, ports, railways - were accompanied by huge volumes of credit-fuelled private projects, including many skyscrapers, shopping malls, and luxury hotels. The decade-long surge in growth has underpinned Erdogan's popularity with a large part of Turkey's electorate.

But during the same period, the ratio of accumulated debt to annual incomes has also massively increased for businesses, households, and consumers. Loans to Turkey's private sector more than quadrupled since 2008, even though the country's real GDP only increased by a third.

That leads critics like Forbes columnist Jesse Colombo to argue that Turkey's growth has been driven by an unsustainable debt bubble that must soon come to a crashing halt.

International investors are a key factor driving interest rates

Orthodox economists say that when a country's real interest rate - the interest rate after inflation is subtracted - is near zero, or burdened by too much political risk, international money leaves the country to seek better or safer returns elsewhere.

This is highly relevant to Turkey, because 90 percent of Turkish corporate debt is denominated in foreign currencies. That dangerously exposes the country's corporate borrowers if the value of the Turkish lira currency drops - as it has done during the past year, when it declined by nearly a fifth against the U.S. dollar.

Moreover, in an environment of very low real interest rates, domestic bank lending tends to grow excessively.

Is Turkey's post-2002 economic miracle a classic bubble?

In many countries, the bulk of bank lending is for real estate mortgages - whether to buy existing land and buildings, or to build new ones. Turkey is no exception.

Real estate investors tend to make purchase decisions based on how large a monthly payment they can afford, based on their monthly income. The lower the interest rate, the lower the monthly mortgage interest payment - and that means buyers can afford a higher principal payment, given the same total monthly housing outlay. This leads to a trend for the price of land and housing to increase as interest rates fall.

Unfortunately, the reverse is also true. If interest rates begin rising again - for example, if the central bank deems it necessary for rates to rise to attract foreign buyers to the Turkish lira, in order to strengthen its exchange value - then the high land and housing prices locked into purchase agreements when interest rates were low now become unaffordable.

That's essentially what happened during the Global Financial Crisis (GFC) that began in 2008 in several countries, including Spain, Ireland, and the USA, when their respective mortgage bubbles burst. The aftermath included a huge wave of bankruptcies, insolvent banks, and massive increases in unemployment, along with a major increase in public debt as nations bailed out some banks and simultaneously faced lower tax revenues and higher social welfare expenditures.

Virtually overnight, Spain went from having low unemployment and a public budget surplus during the several years prior to the 2008 GFC, to high unemployment and a massive deficit during the years since.

If Jesse Colombo and other critics are right, Turkey may soon experience a denouement very similar to that of Spain in 2008.