Turkey's Erdogan set for economic U-turn and steep interest rate hike

Turkey is poised to reverse some of the unorthodox economic policies of President Recep Tayyip Erdogan as his new economic team tries to bring down rampant inflation.

Less than a month after Mr Erdogan won re-election, interest rates are expected to rise dramatically from the current level of 8.5%.

Inflation is almost 40% and Turks are in the grip of a cost-of-living crisis.

But Turkey's leader has so far insisted on keeping interest rates down.

The big question is how far the key policy rate will rise. Economists are divided on how sharp the hike will be, with US-based investment bank Morgan Stanley suggesting an 11.5-point increase to 20%, while Goldman Sachs expects the rate could hit 40%.

Other economists believe the rise will be steep, but possibly more gradual.

President Erdogan's problem is that Turkey's inflation rate remains stubbornly high and its central bank's reserves have fallen to critically low levels, after it spent billions of dollars trying to prop up the lira.

Economists widely advocate raising interests to tackle high inflation, but Turkey's leader sacked three central bank governors in less than two years when they tried to stick to orthodox policies.

Interest rates have come down from 19% two years ago to 8.5% in recent months. Now they are set to rise again, and that will have repercussions for a country already in economic crisis.

"It is a risk, but it's a difficult circle to square," says Ozge Zihnioglu, senior politics lecturer at the University of Liverpool. "He has to do something for the economy, but a clear shift to orthodox economic policies would hit a large section of society and he wouldn't want to have that impact on local elections [next year]."

Turkey's economy grew dramatically in the early years of President Erdogan's leadership. But in recent years, he has ditched traditional economic wisdom by blaming high inflation on high borrowing costs and seeking to stimulate economic growth.

In the past five years, the Turkish currency has lost more than 80% of its value and foreign investment has plummeted. Turks are now trying to move foreign cash out of local banks.

Mehmet Kerem Coban of Kadir Has University said Turkey's economic model needed capital to survive because its reserves had melted away.

Mr Erdogan has been in power in Turkey for more than 20 years. He defeated his opposition rival last month in elections that international observers said suffered from an "unlevel playing field" that gave the incumbent president an unjustified advantage.

During the election campaign, he maintained his mantra that interest rates would stay low as long as he was in power, guaranteeing that there would be no change in economic policy. The opposition promised to reverse his focus on low interest rates.

And yet within days of his re-election, he signalled a change.

First, he appointed former banker and economist Mehmet Simsek as finance minister. Although a former member of Erdogan's government, Mr Simsek has made clear Turkey's only economic choice is to return to "rational ground" and "compliance with international norms".

Next, he appointed Hafize Gaye Erkan, 44, as Turkey's first female central bank chief. A well-known figure on Wall Street, she has never had a role in Turkey before and was chief executive of US bank First Republic before its collapse.

Mr Erdogan said last week that his position on interest rates had not changed, but "we accepted that [Mr Simsek] should take the necessary steps rapidly and effortlessly with the central bank".

Emerging markets specialist Timothy Ash believes Ms Erkan will have to "front-load rate hikes", rather than introduce them gradually. The risk, he warned on Twitter, was that she would share the same fate as a predecessor, "always playing catch-up with the market and waiting in the ante-room of the presidential palace to plead for rate hikes".