In the shadow of hot money: High interest rates, a strong TL, and the accumulating vulnerabilities of the Turkish economy

Economies sometimes grow with numbers, and sometimes only the numbers grow. The difference between the two is of vital importance for a country's economic future. This is because lasting prosperity depends on the expansion of production capacity, increased productivity, the acceleration of technological transformation, the strengthening of investments, and the enhancement of the economy's international competitiveness. Conversely, monetary and exchange rate policies implemented during certain periods may create a short-term improvement in basic economic indicators while weakening the economy's production and competition dynamics over time.

The economic policy based on high interest rates and a strong Turkish Lira that Turkey has recently pursued is a process that must be evaluated carefully in this regard. Keeping interest rates high to combat inflation, allowing the increase in the exchange rate to remain significantly below the inflation rate, and permitting the real appreciation of the Turkish Lira have produced positive results on financial indicators in the initial phase. A certain improvement has been achieved in inflation expectations, foreign exchange reserves have strengthened, portfolio inflows into the country have increased, and a more stable outlook has emerged in financial markets compared to the previous period.

However, the success of economic policies cannot be measured solely by looking at today's interest rates, exchange rates, reserves, or financial market indicators. The real issue is the economic foundations upon which the achieved stability is built. If a significant portion of the increase in reserves relies on short-term capital inflows attracted to the country due to high interest rates, if the real appreciation of the Turkish Lira encourages imports while eroding the exporter's competitiveness, and if high financing costs suppress production and investment, then some indicators that appear positive today may be harbingers of tomorrow's vulnerabilities.

Therefore, the fundamental question that must be asked is: What risks are accumulating for the future of the Turkish economy beneath the current image of financial stability?

The answer to this question should not be sought solely in interest rate and exchange rate policies; it must be sought in the nature of hot money inflows, the foreign trade balance, the competitiveness of the industry, investment trends, the financing conditions of companies, and the production capacity of the economy. This is because lasting economic stability is possible not by attracting capital to the country with high interest rates, but by establishing an economic structure that can increase production, investment, productivity, and value-added.

BECOMING A CARRY TRADE PARADISE: 'What is not yours is not yours!'

It is noteworthy that a significant portion of the foreign capital directed toward Turkey over the last two years consists of short-term financial capital aiming to benefit from the high interest rate advantage rather than direct investment. This mechanism, referred to as carry trade in international finance literature, is based on profiting from the interest and exchange rate differences between countries.

The system is quite simple. The investor borrows from a low-interest country, brings their foreign currency to Turkey, converts it into Turkish Lira, and directs it toward TL-denominated financial instruments that offer high interest. For example, according to benchmark Central Bank data, while the USD/TL exchange rate was approximately 40.92 TL a year ago, the foreign exchange selling rate is at the 47.91 TL level today. This corresponds to an exchange rate increase of approximately 17 percent. Considering that TL-denominated financial instruments offered returns of around 37-40 percent in the same period, a significant return advantage that can reach approximately 20 points emerges for the foreign investor.

However, the fundamental problem with this capital is that it does not provide a lasting contribution to the economy's production capacity. It does not build new factories, bring new technology, or directly increase export capacity. It mostly benefits from the interest-exchange rate spread and can quickly exit the country when conditions change.

As I emphasized in my study titled "Economic Vulnerabilities Stemming from Hot Money Movements and the Risk of Sudden Stop," published years ago, hot money inflows can support reserves and the image of financial stability in the short term; however, the economy becoming dependent on this capital also increases the risk of sudden outflows and vulnerability.

MONETARY ILLUSION: Getting Rich on Paper

One of the least discussed but carefully evaluated consequences of the strong currency policy appears in national income indicators. A country's Gross Domestic Product is first calculated in its own currency; in international comparisons, it is mostly expressed in dollars. For this reason, movements in the exchange rate can directly affect the dollar-based size of the economy and per capita income indicators.

While the economy grows by 3-4 percent in real terms, the real appreciation of the Turkish Lira can lead to national income in dollar terms increasing far above real growth. In such a case, per capita income rises, and Turkey may move up to higher rungs in international income rankings. However, the fundamental question here is: Are we really producing more and getting richer, or do we look richer in dollar terms due to the exchange rate effect?

For this reason, evaluating the increase in national income in dollar terms as prosperity growth on its own can be misleading. If the citizen's purchasing power, the economy's production capacity, productivity, and competitiveness do not increase to the same extent, the rise stemming from the exchange rate may cause economic performance to be perceived as stronger than it is.

Today, it is necessary to separate how much of the increase in Turkey's national income in dollar terms stems from real production and productivity growth, and how much stems from the real appreciation of the Turkish Lira. Because it is possible to look richer on paper while the exporter's competitiveness weakens, the foreign trade balance deteriorates, and production costs rise.

The measure of lasting prosperity is not a strong currency; it is high productivity, value-added, and competitiveness.

WHY THE EXPORTER IS SOUNDING THE ALARM: Competition we weakened with our own hands!

One of the heaviest costs of the high interest rate and strong Turkish Lira policy is emerging in the export sector. While wages, energy costs, financing expenses, and logistics expenditures in Turkey are rising rapidly due to high inflation, the fact that the exchange rate is not rising to the same extent is pushing the exporter's costs up in dollar and euro terms.

This picture is felt more clearly in Turkey's sectors that are sensitive to price competition. In labor and cost-intensive areas such as textiles, ready-to-wear, footwear, furniture, agriculture, and food, the producer is forced to struggle both with rising costs at home and with competitors producing at lower costs in foreign markets. The fact that the exchange rate increase remains behind inflation narrows the exporter's pricing space and erodes profit margins.

The result of this is not only seen in company balance sheets. Order losses, a decline in capacity utilization, the postponement of investments, and the shifting of some production activities to lower-cost countries are developments that could weaken the economy's production structure in the long term. It is not easy to compensate for the permanent capacity loss that will be experienced, especially in export-oriented sectors.

For this reason, the success of exchange rate policy cannot be measured solely by its suppression of inflation or its provision of short-term financial stability. It must also be examined whether it protects the producer's international competitiveness.

Because one of the fundamental pillars of sustainable growth is exports. If the exporter loses their competitiveness, the one who loses in the long term is not just the exporter, but the entire economy.

SILENT ALARM IN TOURISM: Competitiveness means having a say at the table.

The pressure created by high inflation and a strong Turkish Lira is becoming increasingly evident not only in the export sector but also in tourism. For many years, Turkey has been one of the countries that stood out in the Mediterranean basin with its strong price advantage, service diversity, and high tourism capacity. However, it is observed that this advantage has eroded significantly in the recent period.

The rapid rise in prices in foreign currency terms for many items, from hotels to restaurants, transportation, entertainment, and daily expenses, is turning Turkey into a more expensive destination for foreign tourists. While costs at home are rising with high inflation, the fact that the exchange rate is not rising at the same speed is pushing tourism businesses' prices up in euro and dollar terms.

The fact that tourism revenues are currently high may present a positive picture at first glance. However, sustainable success in tourism should not be evaluated solely by the total revenue figure; it should be evaluated by looking at the number of visitors, per capita spending, length of stay, and price competition against rival countries all together.

If Turkey is losing its price advantage while Spain, Greece, Egypt, Tunisia, and similar destinations are becoming more competitive, today's high revenue figures may make medium-term risks invisible.

The real issue in tourism is not how much revenue is earned in one season, but whether Turkey can permanently maintain its competitiveness in the international market.

WHY THE CURRENT ACCOUNT DEFICIT GROWS: A balloon is colorful and flashy when inflated.

One of the classic consequences of excessively strong exchange rate policies is that they weaken the domestic producer's competitiveness while making imports relatively cheaper. When the increase in the exchange rate remains behind inflation, imported products and imported inputs become more advantageous, while the domestic producer, who produces with high costs at home, remains under increasing pressure.

This process shows its effect not only in consumer goods but also in intermediate goods and raw materials used in industry. While the increased use of imported inputs strengthens the economy's external dependency, the decrease in the exporter's cost advantage negatively affects the foreign trade balance. A structure where exports lose momentum and imports strengthen can cause the current account deficit to grow over time.

The real risk is that the current account deficit begins to be financed not by permanent and productive capital inflows, but by short-term hot money directed to the country with the high interest rate advantage. Such a structure makes the economy more dependent on external financing conditions and investor behavior.

Therefore, the issue is not just the size of the current account deficit; how this deficit is financed is at least as important as its size. A financing model that is not supported by production, exports, and direct investments can increase economic vulnerabilities in the medium and long term while creating an image of stability in the short term.

ACCUMULATING RISK: The Sudden Stop Scenario

One of the most important risks of a financing model based on short-term capital inflows is the process defined in economic literature as "sudden stop." During periods when intense capital inflows are experienced, the exchange rate may appear stable, reserves strong, and financing conditions relatively favorable. However, if this appearance is based on the assumption that capital flows will continue, the vulnerability grows to the same extent.

In the event that investors' risk perception changes, global interest rates rise, expectations regarding the country deteriorate, or the possibility of a rapid loss of value in the exchange rate emerges, capital movements can reverse in a short time. In this case, demand for foreign currency increases, pressure forms on the exchange rate, reserves may decline, and it may be necessary to raise interest rates again to maintain financial stability. As a result, while credit conditions tighten, investments and domestic demand weaken, and economic growth slows down.

Mexico, Argentina, Thailand, and Turkey have faced the heavy consequences created by sudden changes in capital movements in different periods in the past. These examples show that excessive dependence on external financing can affect not only financial markets but also the real economy rapidly.

For this reason, the real issue is not how much capital enters the country, but the nature of this capital, its permanence, and the extent to which the economy has become dependent on this financing. Because an unsustainable financing model can turn an image of stability into vulnerability in a short time.

EQUILIBRIUM ILLUSION: What is behind the devaluation expectation?

One of the fundamental questions that has frequently come to the agenda in the markets recently is: How sustainable is the divergence between the exchange rate and economic realities? In an environment where inflation is hovering at the 30 percent level, the exchange rate increasing in the 15-20 percent band annually means the real appreciation of the Turkish Lira.

Real appreciation can contribute to the fight against inflation in the short term; it can support price stability by limiting the price increase of imported products and inputs. However, the continuation of this policy for a long time can weaken the exporter's competitiveness while making imports more attractive and creating pressure on the foreign trade balance. For this reason, expectations that there may be a correction in the exchange rate from time to time are strengthening in the markets.

Of course, this does not necessarily mean that a sudden and harsh devaluation will occur. Exchange rate balancing can also take place through a controlled process spread over time. The real issue here is the extent to which the difference between the exchange rate and inflation, productivity, the foreign trade balance, and capital movements can be sustained.

Economic history shows that prices that diverge from economic fundamentals for a long time enter a search for a new equilibrium sooner or later. The exchange rate is not outside these fundamental economic relationships either. For this reason, what is important is not the exchange rate's current level, but under what conditions and for how long the current equilibrium can be sustained.

CONCLUSION: STABILITY OR ACCUMULATED RISK?

The Turkish economy is in a significant search for equilibrium today. The fight against inflation is undoubtedly mandatory; however, an economic structure that weakens production capacity, export competition, and investment appetite while trying to ensure price stability is not sustainable in the long term. The success of economic policies should be measured not only by the decline in inflation but also by what kind of production and competition structure emerges at the end of this process.

Likewise, the rise of national income and per capita income indicators in dollar terms through the real appreciation of the Turkish Lira does not mean a real increase in prosperity on its own. A country does not get rich through the calculation advantage provided by the exchange rate; it gets rich through its production power, productivity, technological capacity, qualified human capital, and international competitiveness.

For this reason, it is important with what sources today's financial stability is provided. If high interest rates attract short-term capital while a strong TL makes exports and production difficult, encourages imports, and the economy becomes increasingly more dependent on hot money inflows, it may become inevitable for new vulnerabilities to accumulate beneath the visible stability.

Economic history has shown the same truth repeatedly: Hot money is temporary. Exchange rate advantage is temporary. Monetary illusions are temporary. What is permanent is production.

Because economies that lose their production power and competitive capacity may look rich for a while longer; but they cannot remain rich for a long time.