Mahfi Eğilmez lists the economic mistakes of the last 3 years: There is no easy way out of this without suffering damage

Economist Mahfi Eğilmez shared his assessments regarding the Turkish economy in an article published on his personal website.

Summarizing the economic policies implemented by the AKP government over the last 3 years, Eğilmez emphasized that it is impossible to overcome the mistakes made without suffering damage.

Addressing the comments from foreign investors that the Turkish economy is improving, Eğilmez commented, "If foreign investors are emphasizing that a country is recovering, there are two possibilities: (1) Things may truly be getting better. (2) The foreigners may be praising it because they are making good money from that country."

Eğilmez wrote that the KKM (FX-protected deposit scheme), which the AKP government put into effect to lower the dollar exchange rate, caused the Central Bank to suffer a loss of 818 billion TL in 2023.

Eğilmez's article titled "From KKM to Carry Trade" is as follows:

"Representatives of foreign funds that have invested in Turkish Lira deposits, bonds, or stocks in Turkey are saying that the economy is improving. They argue that this type of capital inflow, the increase in Central Bank reserves, and Moody's upgrading Turkey's credit rating by two notches are proof of the improvement in the economy. Before examining whether the economy is improving, let's evaluate how we got here and what our current situation is. Because if foreign investors are emphasizing that a country is recovering, there are two possibilities: (1) Things may truly be getting better. (2) The foreigners may be praising it because they are making good money from that country."

"THEY PERSISTED IN THEIR MISTAKE"

At the beginning of September 2021, inflation was 19.25 percent, and the Central Bank policy rate was 19 percent. All leading indicators showed that inflation was on an upward trend. At that time, with an incredibly wrong decision made under pressure from the political government, the Central Bank began to lower the policy rate instead of raising it. As a natural result of this terrible mistake, the upward trend in inflation accelerated. Despite this, the Central Bank, under the influence of the political government, persisted in its mistake and continued to lower the policy rate in the following months, and inflation rose to 85.51 percent in October 2022. Despite this disastrous course, the Central Bank continued to persist in its mistake and lowered the interest rate to 8.5 percent in February 2023.

"THE CENTRAL BANK INCURRED A LOSS OF 818 BILLION TL"

As a result of lowering Turkish Lira interest rates, people turned to buying stocks, automobiles, housing, and foreign currency instead of Turkish Lira deposits to protect their assets. As a result of the increased demand for foreign currency, exchange rates and the dollarization rate began to rise. When the political government became concerned about this situation, it took its second major wrong step in the last month of 2021: the FX-protected deposit (KKM) application. Those who deposited money into these accounts were given an exchange rate guarantee, ensuring that at the end of the maturity period, they could get their money back in the same foreign currency and in the same amount, and were also guaranteed to earn interest in Turkish Lira on top of it. The exchange rate cost of this system fell not on the banks, but on the Treasury and the Central Bank. In other words, the banks collected the money, and the state paid the exchange rate difference. This practice caused the Central Bank to incur a loss of 818 billion Turkish Liras in 2023.

"KKM ACCOUNTS ARE BEING LIQUIDATED"

These wrong practices were continued until June 2023. After this date, the new economic management and Central Bank management that took office began to raise the policy rate. The policy rate, which had fallen to 8.5 percent, was gradually raised to 50 percent. On the other hand, steps were taken for the exit from KKM. First, KKM accounts that had been converted from Turkish Lira were liquidated, and then the practice of paying additional interest to those coming from foreign currency was abolished. With this practice, KKM accounts have fallen from the 2.6 trillion liras they reached at the end of 2023 to below 1.9 trillion liras as of today.

"THOSE ENGAGING IN CARRY TRADE TOOK THE RISK"

When the interest rate on Turkish Lira deposits rose to 50 percent, foreign investors brought in foreign currency using a method called carry trade (the method of borrowing cheaply and tying it to deposits at a high rate). A typical example for carry trade is, as expressed somewhat jokingly, the investments of Japanese housewives. Since interest rates in Japan are at a zero level, if one borrows from a bank in Japan at zero interest and deposits it into a Turkish Lira deposit in Turkey for 3 months, one can earn 10 percent interest in three months. As long as the exchange rate does not change, this 10 percent return turns into a dollar interest rate. Since such an interest rate cannot be found anywhere else in the world, carry trade became a very profitable investment. In addition to foreigners, Turks also began to earn dollar interest in the same way by breaking their foreign currency accounts or by bringing in foreign currency they kept in their homes or private bank safes and depositing them into Turkish Lira deposit accounts. If the exchange rate rises by 10 percent or more during this three-month period (if the Turkish Lira loses value), then this gain does not materialize. In other words, the risk in the carry trade application is the risk of the exchange rate rising. Those who engaged in carry trade took this risk and have been proven right so far. Although there is no guarantee announced by the political government or the Central Bank that the exchange rate will not change, the announced measures and interventions indirectly guarantee that the exchange rate will not rise.

There were two more developments after the carry trade. First, as a result of such a large inflow of foreign currency and the tendency to convert foreign currency accounts, serious increases occurred in the Central Bank's reserves. Actually, not much has changed: foreign currencies coming as a result of carry trade have replaced swaps. Therefore, perhaps we will need to replace the concept of "net reserves excluding swaps" with the concept of "net reserves excluding carry trade" to see the real situation. Because these foreign currencies, which currently appear as Central Bank reserves, will fly away at the slightest increase in the exchange rate. Credit agencies, whose main duty is to protect the situation of foreigners investing in the country, also welcomed this reserve improvement with applause, and as a result, Moody's upgraded Turkey's credit rating by two notches.

"KNIFE-EDGE BALANCE"

At the stage where such a wrong economic policy has brought the economy, we are facing many contradictions. If the Central Bank lowers the interest rate, the money that came with carry trade will go back, people will turn to foreign currency again, and this will raise the exchange rate; if the money that came with carry trade goes back, a decline will begin in the Central Bank's reserves. If the exchange rate rises, exporters and tourism professionals will be happy, but inflation will rise because the increase in imported input prices will increase costs and therefore sales prices. If the Central Bank does not lower the interest rate, this time those who engage in carry trade will continue to earn incredible amounts of money from the country's resources. If the government leans on taxes, this time the wage earners, whose purchasing power has already fallen significantly, will be completely devastated. Small tradesmen and SMEs will be in trouble.

If you lead economic policy down the wrong path, the steps you take to fix the resulting deterioration end up fixing one side while breaking the other. We have lived through the past three years with such major mistakes. Now, what is important is how we will live through the next three years. Because the fact that the exchange rate does not fluctuate much is the cornerstone of this knife-edge balance. If the exchange rate rises, the carry trade breaks, the system collapses, and we return to the point where we started. If the Turkish Lira appreciates further, this time the foreign trade balance will deteriorate (exports will fall, imports will rise). Enduring this high interest cost for a long time will devastate the economy. In this case, what needs to be done is to gradually lower the policy rate and start reducing carry trade gains. However, this is a very delicate balance. If wrong steps are taken and rapid interest rate cuts are made, then these incoming foreign currencies will flee, the exchange rate will rise rapidly, and we will return to the same point again.

As you can see, there is no easy way out of this without suffering damage. The recipe for getting out of this with the least damage is to make expectations positive. The way to do this is to implement structural reforms, as was done after the 2001 crisis. It does not seem possible to get out of this situation in a permanent way by changing interest rates, playing with the exchange rate, showing inflation as low, or increasing taxes without embarking on structural reforms, primarily the rule of law, the correction of democracy, and a return to science in education."