Turkey is suffering through its worst economic crisis since 2000, and it is at risk of a significant economic meltdown if appropriate emergency policies are not adopted soon. The Turkish lira has suffered a sharp devaluation in recent months because of Turkey’s rising external debt and loss of confidence in its ability to service this debt in the short run. The lira’s decline was accelerated after August 10 as a result of the deterioration of relations between Turkey and the United States. President Trump showed his frustration with Turkey over many diplomatic issues by doubling tariffs on Turkish metal exports, and this unexpected step triggered a lira sell-off.

To avert an economic catastrophe, similar to what happened to Greece in 2016 and more recently in Venezuela, Turkey must introduce very painful fiscal and financial reforms. How President Recep Erdoğan handles this crisis will most likely define the legacy of his political leadership as prime minister and then president since 2002.

More significantly, it will be the first test of how the new presidential government system. That new system was approved in April 2017 and implemented after the June 2018 presidential and parliamentary elections. The question is whether it can prove useful in managing a significant economic crisis.

President Erdoğan and his AKP party campaigned hard for approval of the constitutional reforms in the April 2017 referendum on the promise that a presidential system will bring more political and economic stability to Turkey. They argued Turkey had suffered severe economic instability under its parliamentary system before the electoral victory of AKP party in 2002, because of weak coalition governments were unable to impose fiscal and monetary discipline. The presidential system, it was argued, will be more capable of resisting populist pressures and factional politics that lead to high fiscal deficits and inflation rates.

In that referendum, the voters approved sweeping political reforms, which abolished the post of prime minister and enhanced the powers of the presidency. It also paved the way for direct presidential elections. After that victory, Prime Minister Erdoğan called for the country’s first presidential election in June 2018, which he won.

The Economy is in Trouble

Even when President Erdoğan was forming his new cabinet after the June election the signs of economic trouble were visible. The government's credit-based growth strategy triggered Turkey’s strong economic growth in recent years. As prime minister for more than thirteen years, Erdoğan encouraged and facilitated large borrowings by firms and households to finance a massive construction boom. Thanks to low-interest rates and easy credit policies of the U.S. Federal Reserve, Turkish firms and banks borrowed large sums in U.S. dollars and euros under the expectation that the underlying projects will be profitable and they can easily service their debt.

As the volume of Turkish firms' hard currency debt increased to alarming levels, experts inside and outside of Turkey called on the Turkish government to prevent excessive borrowing and stabilize the lira. President Erdoğan ignored these warnings and insisted that interest rates must be kept low to sustain strong economic growth. The Turkish Central Bank has increased interest rates since 2017, but so far the rate hikes have not been large enough to stop the devaluation of lira.

The lenders and investors were alarmed by this policy and the steady increase in Turkey’s external debt. These concerns led to capital flight and a gradual devaluation of Lira, which made it even more difficult for the Turkish firms to repay or refinance their debt. When lira-dollar exchange rate was three lira per dollar, a firm with a $10,000 annual interest charge obligation had to raise 30,000 lire. When the exchange rate rose to five lire per dollar, $10,000 became the equivalent of 50,000 lire which was much harder to raise.

The rising borrowing costs have already pushed many Turkish firms (particularly in the construction industry) into bankruptcy, and the government has also suspended funding for several mega-projects in recent months. These budget cuts for major public projects, such as the new Kabatas “seagull” ferry terminal, are caused by lack of fiscal revenues and a desire to contain the fiscal deficit. Turkey’s economic agenda for the coming months also includes a freeze on most government investment projects.

There are now clear indications that the Turkish economy has reached a crisis point, which requires immediate attention. The Lira has suffered a 40 percent devaluation since January 2018, and this sharp devaluation has increased the annual inflation rate to near 18 percent in August.

As a result of the excessive borrowings of past fifteen years, Turkey’s total foreign debt (owed by both public and private borrowers,) is close to $500 billion and $230 billion of this sum must be refinanced or retired in the next twelve months. These short-term hard currency obligations might put many firms at the risk of default. Furthermore, many firms might have to reduce output or suspend operations altogether because of the high costs of imported materials and their inability to pass the rising costs to their customers.

This situation has led to a sharp recession in the construction and real estate sector, which has served as the primary driver of Turkey’s economy in the past decade. But most experts believe directing so much financial resources to the real estate sector was a mistake. As economic weakness spreads to other sectors, the households that are currently suffering under high inflation rates are likely also to face rising unemployment. The credit-financed economic boom resulted in a 7 percent annual economic growth rate in the first quarter of 2018, but economists warn that the economy is at risk of experiencing a deep recession in 2019.

Managing the Crisis Under the Presidential System

There were many steps that the Turkish government could have taken in the past three years to avoid the current external debt crisis. It was also possible in the past six months to prevent the rapid devaluation of lira by a combination of higher domestic interest rates (which were repeatedly recommended by economists and the International Monetary Fund) and better management of diplomatic disputes with the United States. These steps were not taken, and Turkey has come face to face with one of the worst economic crisis of its modern history. There are no pain-free options for confronting this crisis.

The most immediate required step by President Erdoğan is to stop the devaluation of lira. In the medium term, he must find an effective strategy to reduce new borrowing and help Turkish firms with their refinancing needs. Simultaneously, the Turkish government must keep the deficit low by cutting government spending to manageable levels in comparison to government revenues.

These are not easy choices, and the practical steps toward these goals will have adverse effects on millions of Turkish households. The government will have to let public sector wages rise less than the rate of inflation, resulting in a reduction in standards of living for public sector agents. High-interest rates will also raise the costs of borrowing for families and businesses.

Turkey faced similar types of economic crises several times before 2002, particularly in the 1990s. The unpopularity of required measures and reluctance of former governments, under Turkey’s parliamentary system, to pay the political price for implementing them, was the main reason that substantial economic reforms were often postponed or abandoned halfway. As a result, Turkey’s inflation rates in some years approached 100 percent. There is no denying that Turkey’s parliamentary political system had a poor performance in achieving fiscal and monetary discipline. The country frequently suffered from large fiscal and current account deficits and had to request external assistance from the IMF and Western governments to meet its debt obligations. (Turkey also frequently benefited from financial support by the United States and European countries because of its strategic value as a North Atlantic Treaty Organization ally in the Middle East and the Black Sea region.) There was also more economic stability and better economic growth under AK party of President Erdoğan since 2002. But it is now clear that this success had been made possible by excessive borrowing, which has led to the current debt crisis.

President Erdoğan and his economic team are facing the current crisis under a different political system, which has granted many new powers to the president.

Many of these new powers are directly relevant to overcoming the current crisis. The most important advantage of the new system is that the executive branch is less vulnerable to short-term populist pressures. The president is now the head of the government and can directly appoint the cabinet ministers. Moreover, the president’s cabinet is no longer vulnerable to a parliamentary vote of no-confidence. Furthermore, his five-year presidency is more secure regardless of fluctuations in public opinion. For example, to call for an early election, the parliament now needs a 60 percent support as opposed to a simple majority. The impeachment process is also more difficult and less likely to succeed under the new presidential system. This secure tenure makes it easier for a Turkish president to implement painful economic reforms that require two to four years to be effective. If a president is committed to these reforms, he or she does not have to worry about being undermined by unexpected early elections under populist pressure.

Additionally, the new constitution allows for more effective fiscal reforms. Under Turkey’s presidential system, the government budget is drafted by the president (instead of the parliament) and submitted to the parliament for approval. The parliament can no longer impose its own budget law on the executive branch, and if it does not approve the president’s proposed budget, the government is not shut down (which is the case in America). Instead, the government will continue to function under the approved budget of the previous year with an appropriate adjustment for inflation. In the current inflationary environment of Turkey, this new arrangement can have positive consequences if President Erdoğan decides to shrink the budget or increase taxes to reduce the fiscal deficit.

The new presidential system will also give President Erdoğan more power to control the country's massive government bureaucracy. Some budget reduction measures might face resistance not only from ordinary citizens and voters but also from the powerful civil servant and bureaucratic organizations. The military and the civilian government organizations have already experienced a major purge after the failed July 2016 military coup and Erdoğan supporters now fill all key bureaucratic positions. Cutting back the benefits and privileges of civil servants and public enterprise employees will be easier and more effective under the new presidential system. These steps might include a temporary wage and promotion freeze for current government employees and an end to subsidies on goods and services that were exclusively available to employees of some government institutions.

Overall, if President Erdoğan and his team decide to implement any difficult and unpopular measures in response to the current economic crisis, they will have more power to enforce these measures under the new Presidential system in comparison to the previous parliamentary system.

Early Evidence of the Potency of the Presidential System

After waiting for several weeks (since August 10) the Turkish government has finally taken some crucial steps to address the economic crisis. The most significant development was the sharp increase in interest rates by the Turkish Central Bank. On September 14, the Central Bank increased its short-term interest rate from 17.75 percent per year to 24 percent. This 6.25 percent increase was larger than most analysts were anticipating and it caused an immediate 2 percent appreciation in the value of lira against the U.S. dollar.

President Erdoğan reacted negatively to this decision and insisted on his old argument that high-interest rates will not be effective against inflation. He further claimed that this is one of the negative consequences of the Turkish Central Bank’s independence. This comment was meant to assure the president’s base that he does not support this unpopular step and remains consistent in his opposition to high-interest rates.

However, for Turkey’s domestic and foreign investors and creditors, this statement had a mixed message. On the one hand, it was worrisome that the president expressed opposition to a policy that all experts consider an important first step for restoring confidence in Turkey's national currency. On the other hand, it was meant to reassure them that Turkish Central Bank enjoyed significant independence and had no difficulty with defying the President Erdoğan's advice.

But in light of the new Erdoğan’s unprecedented executive power, it is false to interpret the interest rate increase as an indication of Central Bank’s independence and its ability to defy the president. If anything, Erdoğan now has more control over all government agencies that are responsible for economic policy. Only a day before this announcement, for example, President Erdoğan took full control of the country’s sovereign wealth fund by announcing himself as the general director and his son-in-law and finance minister, Berat Albayrak, as the deputy director of the fund. While the central bank enjoyed some degree of independence before the presidential system went into effect, its independence after June 2018 is a result of President Erdoğan's deliberate decision to let it maintain a posture of independence. Furthermore, the behavior of the Central Bank in its previous (July 24) policy meeting, however, demonstrated that it acted in full sensitivity to the priorities of President Erdoğan. For instance, ahead of that meeting, most experts anticipated that the central bank would raise the short-term interest rates to combat the weakening of lira. To everyone’s surprise, the bank left the rate unchanged, and this inaction let to a further weakening of lira in the days that followed.

Therefore, the Central Bank’s September 14 decision to sharply increase interest rates represents a significant shift in President Erdoğan’s policy priorities. It appears that in light of the severity of the crisis he has finally accepted that fighting inflationary expectations and restoring investor confidence in Turkish Lira must take priority over any concerns about preserving economic growth.

The credit for changing President Erdoğan’s mind about interest rates goes to his son-in-law, Mr. Albayrak. Recent statements by Albayrak, who is the head of president’s economic team, indicate his strong commitment to a robust anti-inflationary response. It now appears that he has finally convinced Erdoğan that raising interest rates and taking other strong measures against inflation and fiscal deficits, is the only viable option for avoiding an economic meltdown and must take priority over other economic objectives.

Bold Fiscal Steps

In addition to raising interest rates, the Turkish government has announced several necessary steps in recent weeks to show its commitment to restoring the fiscal balance. President Erdoğan who has developed a reputation for initiation a large number of public sector mega-projects, issued a decree on September 14 to freeze all public sector investment projects that are less than 70 percent complete. This will allow the government to achieve considerable fiscal savings by freezing many projects that are in early stages of implementation. Further cost-saving steps include a reduction in public organizations’ car-transport budget and a significant decrease in their occupancy of rental properties.

Albayrak has also provided some early information on the government’s medium-term economic program, which is scheduled for release in late September. Based on his comments there will be a substantial shift toward reduction of government expenditures and budget deficit. Furthermore, to stabilize the economy, the most substantial fiscal saving steps are scheduled for 2019 with a deficit target of under 1.5 percent of GDP. Since the government announced a similar program last year—which did not lead to economic stability—many observers might be skeptical about the government's ability and commitment to this updated program. However, this updated program has a better chance of being implemented because there seems to be a consensus among President Erdoğan and his economic team about the severity of the current crisis, and he now has sufficient executive power to implement deep reforms.

It is in the implementation phase of these spending cuts that the vast powers of the presidency and the executive branch will become crucial. The government is likely to face considerable populist pressure against these measures in the near term. Furthermore, unless the burden of these economic sacrifices is distributed in a fair and transparent manner, perceptions of corruption and nepotism could cause resentment and social unrest.

As significant as these fiscal steps are the Turkish government is yet to announce how it is going to prevent a default on Turkish firms’ large external debt in the next twelve months. There is no guarantee that the monetary and fiscal steps that have been initiated in recent weeks will be sufficient to restore confidence in Turkey’s ability to service its debt. The inevitable economic recession in 2019 will also reduce the revenue potential of may heavily-indebted firms. Consequently, it is likely that Turkey might have to ask the International Monetary Fund for assistance—something that President Erdoğan and Mr. Albayrak have so far firmly rejected. Yet even in any potential negotiations with the IMF, the new executive powers of President Erdoğan will make a crucial difference. If it turns out that Turkey needs substantial short-term assistance—perhaps in the range of $50 to $100 billion—then it is likely the IMF will demand even deeper fiscal and monetary reforms than what Turkish government has announced in recent weeks. In this case, the Turkish government will find it easier to withstand the strong domestic criticism and resistance that implementations of IMF demands are likely to cause.

A Word of Caution

While the new presidential system will make the Turkish government more effective in dealing with the current economic crisis, democratic freedoms—particularly freedom of information, journalism, speech, and debate—are also essential. These freedoms allow people and experts to detect the shortcomings and abuses of the stabilization program. They also provide a channel for opposition parties and independent experts to communicate their suggestions and concerns about economic policies to the government and the citizens.

The adherence of the Turkish government to these freedoms and other democratic institutions would also be reassuring to international and domestic investors about the transparency of the economic and financial systems. They also play a crucial role in preventing corruption and crony capitalism, which have frequently undermined economic reforms in emerging market countries. For instance, the vital role of democracy and the rule of law for the long-term economic progress of Turkey were articulated recently by the prominent economist Daron Acemoglu.

Finally, without proper consultation and feedback, the unprecedented powers of the executive branch can be used to implement harmful and counterproductive policies that can easily worsen the crisis. Turkey’s current critical situation is no time for experiments with untested policies based on the personal beliefs and understandings of any one political leader or policymaker. Instead, independent-minded and well-qualified experts in economic management and finance should be summoned for regular consultation regardless of their affiliation with any political party.

Nader Habibi is the Henry J. Leir Professor of Practice in political economy of the Middle East at Brandeis University’s Crown Center for Middle East Studies. Before joining Brandeis University in June 2007, he served as managing director of economic forecasting and risk analysis for the Middle East and North Africa in Global Insight Ltd.

Image: Turkish President Tayyip Erdogan sits during an interview with Reuters in Manhattan, New York, U.S., September 25, 2018. Picture taken September 25, 2018. REUTERS/Andrew Kelly