Turkey's Lira Crisis: Erdogan's Unorthodox Policy and 2021 Collapse

The Midnight Decree

At 1:25 a.m. on Saturday 6 July 2019 the Resmî Gazete, the Turkish Republic's Official Journal, posted a single-sentence presidential decree to its website. Murat Çetinkaya, governor of the Türkiye Cumhuriyet Merkez Bankası — the Central Bank of the Republic of Türkiye, known by the acronym CBRT — was relieved of his duties with immediate effect, fourteen months before the expiry of his statutory four-year term. No reason was given. Murat Uysal, Çetinkaya's deputy, was appointed in his place by the same decree. The lira opened on Monday morning at 5.74 to the dollar, weaker by about one percent, and recovered most of the move by lunchtime — the market had read the firing as the prelude to rate cuts and the prelude to rate cuts as a known fact already in the price.

What the market did not yet price was that this would be the first of five governor dismissals in fifty months, the start of a public experiment in which a head of state declared that high interest rates were the cause of inflation rather than its standard treatment, and that the textbook reaction function would be inverted by presidential order. By the time the lira found a floor in 2024 it had lost roughly 89 percent of its value against the dollar from its early-2017 level. Consumer prices had risen by a cumulative factor of more than seven. The CBRT had been led by four different governors and had cut rates by 1,425 basis points between July 2019 and February 2023 while CPI inflation accelerated from single digits to a peak above 85 percent. As the MIT economist Daron Acemoglu wrote in 2022, what was on display was not bad monetary economics — the macroeconomic textbook was perfectly intact — but the demonstration effect of institutional capture, the Turkish experiment in dismantling central-bank independence in real time (Acemoglu, 2022).

How Turkey Got There

Twenty years before the midnight decree, Turkey looked like the opposite kind of story. After the February 2001 banking crisis, which had wiped out roughly a fifth of GDP and forced a free float of the lira, Kemal Derviş — a World Bank vice-president recalled to Ankara — pushed through a reform package whose centrepiece was an explicit CBRT independence statute. The 2001 amendment to Law 1211 gave the central bank a single primary objective, price stability, and removed the Treasury's authority to direct monetary policy. Inflation targeting was adopted formally in 2006. The lira stabilised between 1.2 and 1.6 to the dollar from 2002 to 2008, CPI inflation fell from 68 percent in 2001 to 6.5 percent by 2010, and Turkey became a fixture in emerging-market portfolio inflows. Recep Tayyip Erdogan, who became prime minister in March 2003 and president in August 2014, presided over GDP growth that averaged 5.7 percent a year through 2007.

The model had a fragility that successive IMF Article IV missions flagged from 2010 onwards — growth was financed by a structural current-account deficit that was itself financed by short-duration foreign capital inflows, channelled into FX-denominated borrowing by Turkish banks and corporates. Total private-sector FX debt rose from $97 billion in 2003 to roughly $350 billion by 2018, with construction and energy companies particularly exposed. The textbook fear-of-floating problem — that emerging-market economies with FX-denominated balance sheets cannot tolerate currency depreciation because depreciation itself bankrupts domestic borrowers — was Turkey's structural condition long before the political-economy story arrived (Calvo and Reinhart, 2002). When the political story did arrive, it landed on a balance sheet already designed to amplify it.

The First Crisis — August 2018

The trigger in 2018 was external. In July, US-Turkey relations broke over the detention of Andrew Brunson, an American pastor held since the 2016 coup attempt. President Trump imposed sanctions on the Turkish interior and justice ministries on 1 August and doubled steel and aluminium tariffs on 10 August. The lira, which had opened the year at 3.79 to the dollar, fell from 4.85 on 1 August to 6.88 on 13 August — a depreciation of roughly 30 percent in twelve trading days. Yields on five-year sovereign eurobonds widened from 350 to 700 basis points over US Treasuries. Calculated in dollars, the equity market lost a fifth of its capitalisation in two weeks.

Çetinkaya's CBRT, after considerable presidential resistance, responded orthodoxly. On 13 September 2018 the one-week repo rate — the policy rate — was raised from 17.75 percent to 24.00 percent, a 625 basis-point move at a single meeting that exceeded market expectations of a 350 basis-point hike. The lira stabilised around 6 to the dollar through the autumn, the eurobond curve narrowed, and the immediate FX crisis closed. The cost, from Erdogan's perspective, was the public spectacle of the central bank doing the opposite of what he had explicitly demanded. Two weeks earlier, on 25 August, he had told an AKP rally that "interest rates are the mother and father of all evil" and that he was "running out of patience" with those who disagreed. The September hike was the act of disagreement.

The Theory and the Dismissals

Erdogan's heterodox position is sometimes treated as a religious objection to riba — interest is prohibited under classical Islamic jurisprudence — but the textual record from 2018 onwards is more specific. In a televised interview on Bloomberg in May 2018 Erdogan said: "When the central bank policy rate is high, inflation is high. When the policy rate is low, inflation is low." His advisers articulated the same proposition in cost-channel terms: high financing costs raise firms' marginal costs and pass through to producer and consumer prices. The proposition is not absurd as a partial-equilibrium description of certain industries — a firm whose interest expense is a meaningful share of its output cost will, in a duopoly, pass some of that cost forward — but as a general-equilibrium claim about an economy with a floating exchange rate and FX-denominated liabilities it ignores both the aggregate-demand channel and the FX channel, the latter being precisely Turkey's binding constraint.

The dismissals enforced the theory. Murat Uysal cut rates from 24.00 percent to 8.25 percent between July 2019 and May 2020 as inflation drifted between 8 and 12 percent. Uysal was replaced on 7 November 2020 by Naci Ağbal, a former finance minister, after the lira fell through 8 to the dollar on a single afternoon. Ağbal raised rates to 19.00 percent over four months and oversaw a brief lira rally to 7. He was fired by midnight presidential decree on 20 March 2021, two days after a 200 basis-point hike, after barely four months in office. Sahap Kavcioğlu, an academic and AKP-aligned newspaper columnist who had publicly criticised Ağbal's rate increases, took his place. Lira spot opened on the Monday morning 15 percent weaker, the largest single-day move since the 2001 free float.

The November 2021 Collapse

The acute phase of the crisis began on 23 September 2021 when Kavcıoğlu's CBRT cut the policy rate by 100 basis points to 18.00 percent — the first cut of a sequence that would take rates from 19.00 percent in March 2021 to 14.00 percent by December 2021. Each cut came against headline CPI that was accelerating, not decelerating, and against a producer-price index that ran well above headline as the lira depreciated. The four cuts between September and December removed 500 basis points of policy rate while CPI rose from 19.6 to 36.1 percent, opening a negative real-rate gap of nearly twenty percentage points by year-end.

The price action between 19 November and 20 December 2021 was the visible part of the structural problem. The lira fell from 9.55 on 5 November to 13.45 on the day after the 18 November rate cut, then accelerated through 15 in late November and 17 in mid-December, touching 18.36 at the intraday low on 20 December — a depreciation of 92 percent in seven weeks against the dollar. Turkish corporates and households moved into dollar deposits at a pace the CBRT data series records as roughly $11 billion in November alone. Istanbul gold dealers reported queue-times of two and three hours. The Mavi Jeans CEO said in a CNN Türk interview that his sourcing department was rewriting cost sheets every forty-eight hours because each weekly contract was priced in dollars and each weekly receivable was priced in lira.

On the evening of 20 December Erdogan announced what would be called the Kur Korumalı Mevduat scheme, or KKM. Turkish residents could open lira time deposits whose return was indexed to USD, EUR or GBP movement plus a floor rate. If the lira fell by more than the deposit rate, the Treasury made up the difference. The contingent liability sat on the public balance sheet rather than the central-bank balance sheet, but its purpose was identical to a foreign-exchange intervention — to remove the depreciation premium from saver behaviour. The lira closed the next day at 11.10, a 40 percent rebound from the previous evening's low. The intervention had worked in the short term. Over the longer term, the scheme accumulated outstanding balances above 3.4 trillion lira (roughly 130 billion dollars) by mid-2023, and would become a major fiscal cost when the rate gap eventually closed.

The Rate-Inflation Gap

The negative real-rate gap that drove the crisis is best seen quarter by quarter.

The table is a clean read on the entire experiment. The two quarters when Çetinkaya's CBRT had positive real rates — Q1 and Q2 2019 — coincide with the lira stabilising. The negative gap that opens in Q4 2021 is the cutting cycle. The deepest gap, Q2 2022 with a real rate of minus 64.6 percentage points, coincides with the steepest leg of the lira depreciation and with CPI hitting the 85.5 percent peak in October 2022. Even after the orthodox reversal, the gap closes only slowly because inflation expectations stay anchored to the depreciation history rather than to the new policy rate — a credibility cost that the Şimşek-Erkan team would inherit.

The June 2023 Reversal

By the spring of 2023 the structural cost of the experiment had become measurable. Net international reserves at the CBRT, calculated on the central bank's broadest definition that includes swaps with domestic banks, had turned negative — the most-cited estimate by Goldman Sachs put gross reserves at $94 billion against swap liabilities of $108 billion as of late March 2023. The KKM scheme's contingent liability passed 3 trillion lira. Real wages, in dollar terms, had fallen to roughly half their 2017 level. The May 2023 presidential election went to a run-off on 28 May, which Erdogan won with 52.18 percent. Within nine days of his inauguration he had named Mehmet Şimşek as Finance Minister and Hafize Gaye Erkan, a former co-CEO of First Republic Bank in California, as CBRT governor. Both were market-orthodox appointments. Şimşek had served as deputy prime minister for the economy from 2015 to 2018 and had a Merrill Lynch background; Erkan was a Princeton-trained banker whose appointment surprised even orthodox observers in its clarity.

The rate path tightened immediately. The policy rate was raised from 8.50 percent in June 2023 to 15.00 percent at the 22 June meeting, then in successive moves to 17.50, 25.00, 30.00, 35.00, 40.00 and 42.50 by year-end. Erkan resigned in February 2024 amid an unrelated controversy and was replaced by Fatih Karahan, a former New York Fed economist, who took the rate to 45.00 in February and 50.00 in March. The lira stabilised in a band between 27 and 32 against the dollar through the summer of 2023 and ran slowly to 35 by late 2024. KKM balances began to run off as depositors rotated into ordinary lira deposits at the new high rates. The disinflation took longer than the rate-hike path implied — CPI was still running above 60 percent at the start of 2024 — but the cycle had turned.

What Turkey Inherited

The structural cost of the experiment shows up in three places. First, the cumulative depreciation of the lira from its early-2017 level of roughly 3.5 per dollar to its late-2024 level of roughly 35 per dollar is a 90 percent fall in dollar terms, leaving real wages and household FX-denominated debt at far more punishing levels than the orthodox alternative would have produced. Second, the KKM scheme transferred between 800 billion and 1.4 trillion lira of depreciation cost from saver balance sheets to the public balance sheet during the period when it was active, depending on which methodology is used to compute the realised payouts (CBRT, 2024). Third, the credibility of CBRT inflation forecasts was destroyed for at least a policy cycle — survey-based one-year inflation expectations remained above 35 percent through 2024 despite a 5,000-basis-point cumulative tightening that would, in a normal credibility regime, have re-anchored them within a year.

The parallels to the 1990s emerging-market currency crises are visible without being identical. The negative-real-rate phase that Turkey ran from late 2021 through mid-2023 resembles in shape the run that preceded the 1998 Russian rouble devaluation and GKO collapse, where official rates had been kept below market clearing for political reasons until the deflation in oil prices made the regime untenable. The mechanics of the lira's December 2021 spike — a self-reinforcing depreciation as residents rotated savings out of the local currency — was the same mechanic that produced the 1994-1995 Mexican peso crisis and the Tequila Effect. The deeper structural inheritance — a current-account deficit financed by FX-denominated short-term borrowing in a country with a politicised central bank — is the configuration that produced the 2001-2002 Argentine collapse when its convertibility regime broke. Where Turkey differs is the speed of recovery in nominal output, which the contagion of those earlier episodes lacked, and the absence of a sovereign default, which the FX-protected deposit scheme was specifically designed to avoid.

What Turkey shares with the canonical disinflation case — Paul Volcker's campaign of 1979-1982 at the Federal Reserve — is the structure of the eventual turn. Both episodes required real policy rates well into positive territory, both required public commitment that those rates would stay there for longer than the political cycle wished, and both required the central-bank chair to absorb the political cost of doing so. The difference is that Volcker did it from a position of statutory independence that the Fed had inherited from a half-century of accumulated institutional capital, while Erkan and Karahan did it as appointees of a president whose theory of inflation had not formally changed. As one Istanbul-based asset manager put it to the Financial Times in October 2023, "the rate path is now orthodox, but the regime is one missed disinflation print away from being unorthodox again."

The KKM balance is the cleanest summary of what the regime cost. The peak holdings — roughly 130 billion dollars in lira-denominated deposits with a state-guaranteed FX hedge — represented about thirteen percent of Turkish GDP and were the price paid to stop the December 2021 run. By late 2024 most of that paper had been run off without producing a fiscal accident, which is the closest thing to a happy ending the episode allowed. The lira sat at thirty-five to the dollar, ten times its 2017 level. The cycle from heterodox theory to orthodox reversal had taken five years and consumed five central-bank governors. On the evening of 22 June 2023, when the CBRT raised the policy rate by 650 basis points to 15 percent, a senior Şimşek aide answered a question from a CNBC reporter about whether the new team would have full operational authority with a single word: yarın. Tomorrow.