Turkey's low-interest time bomb

Just a little over a month before the next election, Turkish President Recep Tayyip Erdogan is under pressure and not least of all because of the economy. Although he can boast of impressive growth — 7.4 percent last year — many economists doubt that the numbers reflect the true state of the Turkish economy.

Read more: Turkey wants to join EU within 5 years: deputy PM

Even if you believe the official statistics, the problems are obvious. Unemployment is high, especially among young people.

"A significant portion of the growth is based on domestic consumption," says Erdal Yalcin, political economist at the Konstanz University of Applied Sciences (HTWG). His calculations include major state-backed construction projects as well as spending by companies and private households — all financed on credit.

As a result, the Turkish lira has steadily lost value, which is a real problem for a country that imports more than it exports. The inflation rate is currently around 11 percent — more than twice the 5 percent targeted by the country's central bank.

All evil combined

To counteract the decline of its currency, the central bank would have to raise interest rates. "Turkey needs foreign capital to sustain consumption-based growth," says Yalcin. "But investor confidence is dwindling. It's a time bomb."

Not only has the central bank so far been hesitant to increase interest rates. President Erdogan is putting pressure on the technically independent institution to cut interest rates. High interest rates are "both the mother and father of all evils," he said last Friday. And he told Bloomberg TV this week that he would tighten his grip on the central bank should he win the election.

For a large group of voters the president has hit a nerve. Indebted companies and families are unsurprisingly against raising interest rates. But to the outside world — especially the capital markets — Erdogan is sending a dire signal and the lira continues its downward slide.

This in turn is especially troublesome for large Turkish companies because they have often borrowed in foreign currencies. The lira's losses make these debts more expensive and will bring some to the brink of insolvency.

A question of creditworthiness

The yield on Turkish government bonds has also risen to record levels. In other words, investors are no longer willing to lend money to the country on the same terms. At the beginning of May, the American rating agency S&P lowered its rating for Turkish credit to BB-. Moody's, another major rating agency, already downgraded the country in March.

All this leaves the government, companies and ordinary citizens little room to maneuver. And just now, when they are so dependent on cheap credit, the flow of capital is threatening to dry up.

The president has reacted as he often does with sweeping blows designed to rack up political points at home. "We are not interested in Turkey's enemies, who are hiding behind currency rate speculators, the interest rate lobby, or credit rating agencies. These are not our concern," declared Erdogan in front of a group of company representatives.

An exodus of capital?

Strong words regardless of collateral damage — really nothing new for Erdogan. "But this time it really made a bang," says Yalcin. "If the Turkish lira continues to lose value, it could lead to a so-called fire sale, in which foreign capital leaves the country within a few days."

Even with capital controls Erdogan could not prevent such an outflow, according to Yalcin. The economic truth is that Turkey faces difficult times. "Businesses and families will end up insolvent and bankrupt, because debt-based policies can't work in the long term."

Yalcin also sees the deteriorating economic situation as a reason behind Erdogan's decision to move up the elections which were originally planned for November. Election day is now scheduled for June 24, and for the first time ever the president and the parliament will be elected on the same day.

What now, Turkey?

Regardless of the outcome of the election, the question comes up as to how the economic situation of the country can be improved. "A core problem is of course uncertainty," says Yalcin.

Investors are increasingly deterred by tense relations with the European Union, Turkey's main trading partner. And they are wondering which direction the increasingly autocratic president is taking the country.

As recently as March, Erdogan said he continues to seek full EU membership. But the European Commission reacted coolly. Johannes Hand, who is in charge of EU membership bids, told a news conference in April that the country "continues to take huge strides away from the EU, in particular in the areas of rule of law and fundamental rights." The report he was presenting concluding that "Under the current circumstances, there are no plans to open new chapters [in the accession negotiations]."