Proposed Institutional Reforms Risk Undermining Mexico's Ability to Attract Foreign Direct Investment (2024)

Mexico’s president-elect pledge to implement a potentially major institutional and judicial reform has increased investor nervousness and, if it is implemented along more radical lines, would diminish Mexico’s attractiveness as a destination for foreign investment at the every moment when the country was supposed to benefit from global supply chain restructuring. Similar to populist politician elsewhere, Mexico’s left-wing leaders see existing institutions as representing the deep state that prevent political change. But proposals to substantially reform or weaken existing institutions could heighten domestic and foreign investor concerns about Mexico’s institutional stability and predictability. Radical judicial reform would deter portfolio and especially foreign direct investors at a time when geopolitically driven economic fragmentation, de-risking and friend-shoring was making Mexico an increasingly attractive investment destination. 

> On June 2, Claudia Sheinbaum of the left-wing Morena party was elected president and succeeded Andres Manuel Lopez Obrador or AMLO (2018-24). She will serve a single six-year term and will take office on October 1.

> The president-elect’s left-wing electoral alliance Sigamos Haciendo Historia controls 373 out of 500 seats in chamber of deputies and 83 out of 128 seats in the Senate. This gives the alliance a constitutional two-thirds majority in the House, while falling two seats short of one in the Senate.

> On February 5, President AMLO submitted a package of 18 constitutional amendments and two legal reform initiatives that would affect the executive and legislative branch, the electoral system and eliminate various regulatory agencies and autonomous constitutional bodies, among other things.

Mexico’s economy has underperformed in the past few decades, while it proved resilient to external shocks. In the 2000s, the IMF classified Mexico as a high-growth emerging economy. But Mexico never succeeded in growing more than 2.5% on a sustained basis. Explanations for Mexico’s relatively disappointing economic growth vary, including labor market informality, limited human capital and insufficient investment. Mexican economic growth is sensitive to the U.S. economic cycle and in particularly U.S. industrial production given Mexico’s extensive integration into U.S. manufacturing supply chains and the large share (85%) of Mexican exports to the U.S.. But economic shocks like the 2001 dotcom bubble, the U.S.-centered global financial crisis of 2008 or COVID-19 pandemic lead to sharp economic downturn, but they do not prove financially destabilizing due a robust macroeconomic framework, including sustainable debt levels, inflationary targeting by an independent central bank and floating exchange rate. The energy-focused reforms under President Enrique Pena Nieto (2012-18) were supposed to unleash Mexico’s growth potential by opening up and liberalizing the Mexican energy sector to foreign investors. But economic growth failed to accelerate. Under President AMLO, the government began again to play a more important role and liberalization and market competition were rolled back. While Mexico’s economic performance does not differ much compared to other large Latin American economies, such as Argentina and Brazil, the latter have experienced far greater economic and financial volatility and instability in the past three decades. 

> Between 2000 and 2023, real GDP growth averaged a mere 1.7%. Under AMLO, real GDP growth expanded 1% a year, compared to 2% under Pena Nieto. This compares poorly to upper middle income economies in Eastern European and Asia. The IMF projects real GDP growth to average 2% in 200224-29. This is roughly in line with historical performance since the pay moratorium of 1982 and subsequent structural reform.

Mexico’s macroeconomic fundamentals are stable, but the government will need to rein the fiscal deficit. During the first few years of his mandate, AMLO stuck to a disciplined fiscal policy, leading to a broadly stable government debt-to-GDP ratio. The COVID-19 shock did lead to a sharp increase in the debt-to-GDP, like everywhere else. However, in the 2024 pre-election budget, the government increased social expenditure and investment, which led to a sharp increase in the deficit, which is expected to reach almost 6% of GDP. Meanwhile, state-owned of oil company Petroleos Mexicanos (PEMEX) required (and will require) government financial support in the context of a continued tangible reliance of the government on oil-related revenues.

> The IMF projects net public sector to stabilize at 50% of GDP, roughly the same level it was in 2020. But the IMF also forecasts Mexico’s fiscal deficit to reach almost 6% of GDP in 2024, a level that exceeds the deficit of 4.3% of GDP during COVID-19 when economic growth collapsed. The MF also predicts a change in the primary balance worth more than 2% of GDP, implying a substantial fiscal adjustment in 2025. If the Mexican government fails to lower the deficit next year, government will continue to increase, even if only gradually. But the risk of a credit downgrade, let alone broader financial instability would remain low as long as the new president remains credibly committed to adjust fiscal policy in 2026-27.

> Oil revenues amount to around 15% of budgetary revenue or a little more than 3% of GDP. This continues to make revenues sensitive to oil prices. But the government’s hedges it oil revenue, making situation manageable. Declining oil production does represent a challenge, but much more so over the medium term. Moreover, PEMEX has significant liabilities, which are contingent liabilities from the government’s point of view. Total liabilities of $106 billion as of 2023, almost half of which is set to mature in the next three years. The government has already allocated $ 10 billion to help PEMEX repay its maturities. With a GDP of around $ 2 trillion worth 5-6% of GDP. This represents a manageable risk in the short- to medium-term.

> Mexico’s net international investment position has been stable at – 30% of GDP. Its current account deficit is less than 2% of GDP and fully financed, generally over-financed by net foreign direct investment inflows in the form of reinvested earnings (rather than greenfield investment and intercompany loans. Mexico also has access to the IMF’s Flexible Credit Line worth $ 35 billion dollars, which more than financing provides Mexico with a seal of approval of its overall economic policies and financial position. The three major international rating agencies assign an investment grade rating of BBB or BBB- (or its equivalent) to Mexico.

Investors are concerned about the outlook for continued institutional stability. A stable, predictable and professional judicial system is important in terms of a country’s ability to attract long-term foreign (direct) investment. Financial markets reacted negatively to the electon outcome, less so because of Sheinbaum’s victory, which was expected, but because of unexpectedly strong performance of her electoral alliance in the congressional elections. With a two-third majority in the chamber and a near-two-thirds majority in the Senate, the likelihood of wide-ranging institutional reforms being approved has increased substantially. The president-elect has lent her support to the proposed reforms, which, among other things, could lead to an overhaul of the judiciary, including the firing of 1,600 judges and their replacement through popular elections. In principle, the reforms could be enacted as soon as September, but Sheinbaum has promised broad consultations, possibly as a way to give excuse to water down the reform. Her cabinet appointment point towards a more collegial, less top-down approach to policy-making. This may also suggest that she might be less keen to push through wide-ranging institutional reforms, particularly if they weigh on investment and economic confidence.

> The peso lost 10% of its value, and Mexican stock markets was down 6% the day after the elections, reflecting investor concerns about the risks associated with (uncertain) judicial reform.

> The nomination of Marcelo Ebrard, former foreign minister and PRD stalwart (and rival for nomination), as Economy Minister in charge of Industry, Trade and Investment and the decision to reappoint Rogelio Ramirez de la O as finance minister are important signals in terms of economic policy.

> Historically, ex-presidents have held little sway over Mexican politics, in part because they cannot run again for president, in part because consecutive re-election of members of the Chamber and the Senate is prohibited. Ousting a sitting president would require 2/3 majorities in both houses. This should limit AMLO’s ability to pressure Sheinbaum to do things she does not want to do.

In the context of reshoring and friend-shoring, Mexico is faced with a unique opportunity to attract foreign investment and integrate itself further into the North American economy. In the 1990s and 2000s, Mexico faced significant competition from low-cost China in terms of U.S. market share. But with international companies, including Chinese and American ones, seeking to diversify their supply chains, Mexico is again becoming a very attractive destination of foreign direct investment. With international companies pursuing supply chains diversification in the context of increasing geopolitical risks, Mexico’s membership in the United States-Mexico-Canada Agreement (USMCA, formerly NAFTA) provides companies with relatively easy access to the U.S. markets in terms of geography and tariffs. 

> The IMF has shown that capital flows, and especially foreign direct, less so trade flows between geopolitical allies has increased, while it has decreased between geopolitical adversaries. To the extent that investment and trade flows are redirected, Mexico should be expected to benefit.

> In 2023, Mexico replaced China as the United States largest import partner for the first time 20 years. Annual FDI inflow data do not yet point to a significant increase in FDI. Inflows have been fluctuating between $25 billion and $35 billion a year. In the first quarter of 2024, the United States accounted for half of FDI inflows.

US Partisan Politics Risks Leading America to Make an Unforced Strategic Error (2024)

(This blogpost was written several months prior to its publication. But its content remains relevant in the context of the foreign policy debate in Washington.) Europe and Germany cannot take timely and sufficient American support for Ukraine for granted. Partisan-political divisions and the prospect of a second Trump administration are creating heightened uncertainty. Brussels and Berlin should make it clear to both American policymakers and legislators that Europe has thus far provided far more total aid than Ukraine than America. They should also emphasize that US support is highly cost-effective in terms of America’s broader, China-focused national security strategy.

The Biden administration’s request for an additional $60 billion of Ukraine aid remains tied up in a hyper-partisan Congress. Worse, a second Trump administration may threaten to reduce or even withhold further Ukraine aid altogether, possibly in an attempt to force Europe to increase its support. To the extent that transatlantic disagreement over cost sharing is amenable to rational argument, Europe should emphasize two important points in its negotiations with America: Europe has already committed to providing much more aid to Ukraine than America; and American aid generates significant economic and strategic benefits to the United States at a comparatively small cost, while a reduction, let a alone complete withdrawal in aid would jeopardize Washington’s broader strategy goals. 

Europe has committed far greater resources to Ukraine than America 

As of October 2023, EU countries, directly and indirectly, have committed about twice as much military, financial and humanitarian aid to Ukraine than America. According to the Kiel Institute for the World Economy, total commitments by EU countries and EU institutions have amounted to $133 billion, compared to $72 billion since the beginning of the war in February 2022. The United States is the largest single provider of total aid ($71 billion) as well as military aid and assistance ($44 billion), followed by Germany (total aid: $21 billion/ military aid: $17 billion) and the UK (total aid: $13 billion/ military aid: $7 billion). As a share of GDP, however, Lithuania and Estonia have been the most generous providers of aid worth 1.8%. By comparison, Germany has provided aid worth 0.9% of GDP (including through EU institutions) and the United States 0.3% of GDP. 

If contributions were adjusted to take into account America’s slightly larger economy compared to the EU-27 (15.2% vs 14.3% of global GDP on a purchasing power parity basis) and its significantly higher per capita income ($80,000 vs $57,000 in PPP terms), Europe’s relative “adjusted” share would be even greater than what is implied by dollar contributions alone. Any transatlantic discussion of how to share the cost of support in future should start from an acknowledgment that Europe is committing far greater resources to support Ukraine than America. Far from free-riding, Europe is pulling its weight.

America’s Support for Ukraine is Highly Cost-Effective in Terms of its Broader Strategic Goals

A second issue European should emphasize is that America derives significant economic and strategic benefits from supporting Ukraine, and it does so at a relatively low cost. Financially, American aid is small, amounting to a little more little more than $70 billion since the start of the, or less than 0.15% of GDP on an annual basis. The $60 billion of additional aid requested by the Biden administration would amount to another 0.2% of GDP in 2024. To put this into perspective, a sustained 100 basis point increase in US interest rates costs the US taxpayer $260 billion, annually. 

Economically, Ukraine aid is not simply “money out of the door”. American aid, unlike EU aid, consists primarily of military aid and assistance. To the extent that military aid comes out of new production rather than existing stockpiles, the money flows directly to the US defense industry and US workers. According to the American Enterprise Institute, 90% of the funds spent stay in the United States. To the extent, however, that aid is financed by debt issuance, the American taxpayer is ultimately accountable for servicing it. But 0.15-0.2% of GDP worth of additional annual spending is as close to a rounding error in GDP terms as it gets.

Strategically, US military aid helps maintain the balance of conventional military power in Eastern Europe, and thus stability and security in Europe. From Washington’s point of view, it does more than that: it weakens Russia strategically. Leaving aside Russian losses in equipment and personnel as well as the impact of sanctions, the continued flow of Western aid to Ukraine is forcing Russia to increase “unproductive” military expenditure, thereby reducing the ability to invest to support long-term economic development. Russia’s trend growth has already decelerated to less than 1% over the past decade, and it is set to decline further, thereby weakening the country’s strategic position.

Keeping Russia at bay militarily in Ukraine is consistent with, and conducive to America’s primary strategic goal, as articulated in the National Security Strategies of both the Trump and Biden administrations: countering China. The war in Ukraine has led Moscow and Beijing to form a closer relationship. Preventing Russian from making gains in Eastern Europe is therefore in America’s best interest in terms of its broader national security strategy. From Washington’s point of view, spending less than 0.2% of GDP a year to prevent Russia, China’s major international partner, from making gains in Ukraine is simply efficient and effective strategy.

Reducing US Support for Ukraine Would Be Nothing Short of an Unforced Strategic Error

A second Trump administration may wager that a reduction of American aid will force the Europeans to increase their support and such a move would not fundamentally change the prospect of Russian gains in Ukraine. After all, Europeans feel more immediately threatened by the war in Ukraine than America. But this is a risky approach to take. A substantial reduction in aid would benefit Russia and might allow it to make military gains. And even if American aid does come through in the end, uncertainty about the availability and timing of future funding might undermine morale in Kyiv and embolden Moscow. Withholding Ukraine is also risky because Europeans, who have delivered more financial than military aid, are not well-placed to replace shipments of US military equipment necessary to support Ukraine effectively.

Washington might insist that Europeans purchase the necessary defense goods from America. But this would lead America to incur significant reputational costs in the eyes of its European and Asian allies. Uncertainty over America’s commitments to its security alliances would increase and weaken America’s geo-strategic position in East Asia. So even if the Europeans manage to increase their financial support to the level required to preserve the military balance in the Ukraine – and it is far from clear that this will happen – withholding or substantially scaling back American support for Ukraine looks like an unforced strategic error in the making. 

Should serious transatlantic disagreement over Ukraine funding emerge, then Europe would do well to point to the significant support it has provided thus far. It should also remind America of the significant strategic and reputational costs it would incur and of the very limited financial savings a reduction of US support would generate if it were to sharply reduce or withhold support altogether. These argument may not sway ideologues among policymakers, nor congresswomen (sic!) under electoral pressure. But they are squarely aimed at the Downsian median “voter” in Congress and pragmatic policymakers. Europeans must hope that America’s strategic interests prevail over populist, partisan domestic politics as well as some of its latest or not-so-latent unilateral-isolationist instincts.

Germany’s Geo-Commercial and Geo-Financial Vulnerabilities Vis-à-Vis China (2024)

As a highly open economy, Germany is at greater risk of sustaining losses in the event of international economic fragmentation, let alone a systemic breakdown of international economic relations. Economic openness also makes it more susceptible to geo-economic coercion. In the event of a war over Taiwan, for example, international and trade financial flows might be severely impacted. Germany’s close economic relations with China would translate into significant losses. Germany should therefore continue to de-risk, particularly with respect to critical imports from China and, less urgently, German direct investment in China.

Trade-related risk is broadly manageable, but dependence on critical imports must be addressed

In terms of trade, Germany is the most open G7 country. Exports and imports of goods and services are equivalent to nearly 90% of GDP. For Japan, the respective figure is less than 40% of GDP and for the United States it is 25% of GDP. However, the bulk of Germany’s trade is with EU partners and geopolitical allies. This helps limit geo-commercial risks.

In 2022, China was Germany’s single-largest trading partner with combined exports and imports equivalent to EUR 300 billion. The United States was Germany’s second most important partner with EUR 250 billion worth of bilateral trade. The United States and China were Germany’s largest and fourth-largest export market with goods being shipped accounting for 4% and 2.7% of GDP. 

While Germany is much more dependent on both China and the United States in terms of trade than vice versa, EU-China and EU-US trade relations are more balanced. Broad-based decoupling would lead to tangible economic losses on both sides. Hence the mutual interest in avoiding a broader trade conflict. In the context of the EU’s trade defense policy, the more balanced EU-China and EU-US trade relationship affords Germany significant protection from potential Chinese geo-commercial coercion. 

Germany’s most significant trade-related vulnerability, and the vulnerability most easily and efficiently exploited is its dependence on critical imports – an import is critical if it is difficult to substitute at a reasonable cost and its lack of availability risks significant economic or social disruption, or lowers national security (e.g. energy, rare earths, semiconductors, medical supplies, defense goods). China accounts for 7% of Germany’s imported intermediate inputs or 1% of German final output. Almost half of all German industrial firms that rely on intermediate inputs from China. This suggests that a selective or wholesale stop of Chinese imports would cause significant economic disruption, even if quantitative measures fail to capture the actual impact of a sudden import stop.

A broad trade war between the EU and China is unlikely given their somewhat comparable level of interdependence. However, selective export restrictions targeting critical goods is a source of potential geo-commercial leverage as well as a potential source of economic losses for Germany. Export restrictions are efficient in that they limit the costs to the coercer, while potentially imposing significant economic costs on the target economy (e.g. 1973 Arab oil embargo). Hence the need to address import-related vulnerabilities.

Geo-financial vulnerabilities are also manageable – at the macro-financial level

Germany is not just the most trade-dependent country among the G7. It is also the largest net international creditor with claims amounting to 70% of GDP. Gross foreign financial claims amount to a massive EUR 12.6 trillion or 300% of GDP. Similar to trade disruption, a breakdown of international and especially financial relations has the potential to cause sizeable financial losses, as the recent (partial) severing of financial ties with Russia demonstrated.

The geographic breakdown of the financial claims matters in view of likely patterns of economic fragmentation and geo-economic coercion risks. In 2023, German companies’ credit claims vis-à-vis non-residents amounted to EUR 1.4 billion (or roughly 35% of 2023 GDP), their liabilities to EUR 1.75 trillion. Again, EU partners and geopolitical allies account for the bulk of international claims. By comparison, credit-related claims vis-a-vis China are small at just EUR 31 billion. This compares to EUR 24 billion of German liabilities vis-à-vis China, which translates into a “net exposure” of just EUR 7 billion. Put differently, German companies’ credit-related financial claims vis-à-vis China amount to less than 1% of GDP. On a net basis, they amount to almost zero. German companies’ credit exposure to China is insignificant from a macro-financial perspective, even if they may represent sizeable risks to individual German companies.

German companies’ foreign direct investment amounted to EUR 1.4 trillion in 2021, or a sizeable 40% of 2021 GDP. Overseas FDI is strongly concentrated in other EU countries, the UK and the USA. Compared to credit-related claims, however, German FDI in China is a sizeable EUR 100 billion. This pales in comparison to the EUR 400 billion worth of German foreign direct investment in the United States, but it is sizeable. German FDI related claims on China are equivalent to 2% of GDP. German foreign direct investment is also highly concentrated with ten companies accounting for 70% of German FDI in China. China also accounts for roughly 10% of German foreign investment enterprises’ annual turnover; America account for almost double . Unlike in the case of companies’ credit claims, German FDI liabilities vis-à-vis China are less than USD 5 billion and therefore do not provide much of an offset in case of losses are incurred on German FDI in China. In short, German FDI in China is sizeable, but from a macro-financial point of view it does not look unmanageable – though a more detailed analysis is required to work out how financial losses might cascade through the German economy in various geopolitical scenarios. 

Economic Policy Making in Highly Centralized Political Regimes – The Case of Turkey (2024)

The Turkish economy has had a good run since the AKP came to power in 2002. Following the currency crisis in 2001, the AKP faithfully implemented and successfully completed two successive IMF programs between 2002 and 2008. Economic growth averaged more than 7% during this time. Over the past two decades, economic growth averaged more than 5% annually, putting Turkey in the category of high-growth emerging economies, comparable to Asia’s top performers. In the past few years, however, continued strong growth was accompanied by high and increasing inflation and a deterioration of Turkey’s international financial position. This coincided with the increasing centralization of Turkey’s political system following the 2017 constitutional reform. In the context of weakening of support for the AKP and President Erdogan and in view of the high-stakes post-reform presidential and general elections in 2023, short-term political calculus dominated economic policymaking at the expense of monetary stability and economic fundamentals.

Monetary policy was not exactly very orthodox before the constitutional reform, but it deteriorated decisively after 2017-18. Turkey’s central bank had started shifting towards a more unorthodox monetary policy as early as 2010, mainly in an attempt to cope with strong financial inflows and exchange rate appreciation. This policy led the CBRT to miss its inflation target near-continuously, but it also made Turkey stand out compared to its top-tier emerging economy peers where inflation was significantly lower (e.g. Brazil, Mexico, South Africa). Starting around 2018, policy turned decisively inflationary. While inflation was high during 2009-16, it typically averaged 10% or so. In 2018-19, inflation reached the mid-teens, before exceeding 70% in 2022, post-COVID-19. 

Macroeconomic policy absent significant checks and balances

Increasing political centralization and a shifting political-electoral calculus helps explain worsening economic policies. When the AKP first came to power more than two decades ago, the AKP gained an absolute majority in the grand national assembly. Economic conditions were improving following the 2001 financial crisis. The AKP won absolute majorities in 2002, 2007, 2011, and following a surprise loss and a repeat parliamentary election, in 2015. In 2018, it failed to win an absolute majority by a narrow margin (295 out of 600). At this point, however, constitutional reform had already weakened the parliament and policy-making had become strongly centralized in the president’s office. The centralization of power, however, was going to make the 2023 presidential a high-stakes election. The centralization of political power provided President Erdogan with both the ability and the incentive to opt for a policy aimed at increasing short-term economic growth. 

Although then Prime Minister Erdogan undoubtedly dominated Turkish politics and the AKP, until the mid-2010s, other senior AKP figures retained a degree of influence, at least over economic policy. The AKP expanded its influence by gaining control over institutions (e.g. presidency) and by weakening institutional opponents (e.g. military, judiciary), the 2017 constitutional reform led to a very significant centralization of power in the hands of the president. At the same time, Erdogan successfully sidelined remaining senior AKP officials, giving him unprecedented sway over his party. The constitutional shift and the sidelining of potential AKP internal opposition gave the president free rein after 2018 with the constitutional changes likely weighing more heavily. The strengthened presidency made it imperative to be re-elected in 2023, even after the AKP lost some popularity and the prospect of an opposition winning increased. In this sense, the constitutional reform created the ability and increased the incentives to pursue less orthodox, pro-growth economic policies. 

The evolution toward a more centralized political regime tracks the deterioration of macroeconomic policy fairly well. Recep Tayyip Erdogan (2003-14) has undoubtedly been the single most dominant political leader in Turkey since Mustafa Kemal. When he first became prime minister (2003-14), however, other senior AKP figures were on the scene and were influential in economic policy making. After resigning the premiership to make way for Erdogan, AKP founding member Abdullah Gul became president (2007-14). Ali Babacan (2002-07) as Minister in Charge of the Economy and later as Deputy Prime Minister (2009-15) was in charge of economic policy and enjoyed the confidence of Turkish industrialists and international investors alike. Later, Mehmet Simsek, much less of an AKP heavyweight than Gul and Babacan, as minister in charge of the economy (2007-09) and then as deputy prime minister (2015-18) managed to hold more or less and increasing difficulty the line on economic policy. With the departure from office of Gul (2014), Babacan (2015) and Simsek (2018), AKP-internal opposition to less disciplined policies crumbled, while the president’s ability to influence central bank policy increased as a consequence of the constitutional reform and the abolition of the office of the prime minister.

Monetary policy became significantly more inflationary and the government began to resort to unorthodox policies in order to limit the negative effects of easy monetary policy on inflation, currency valuation and capital outflows. The CBRT undershot its inflation target in 2002-2005 and 2009-10 (no doubt helped by the global financial recession and recession). While the CBRT failed to meet its five-percent inflation target throughout the 2010s by a smallish margin, policies and inflation took a decisive turn for the worse in 2017-18, as the pressure on the CBRT to pursue expansionary increased substantially. The Turkish central bank has had nine different governors since 2001. It has had six different governors since 2019, several of them sacked or otherwise pushed out of office by the president (Murat Uysal in 2020, Naci Agbal in 2021), as they failed to align with the president’s preference for low interest rates. In 2021, an individual who was aligned with the need to pursue an easy monetary policy was appointed by governor, setting the stage for even more inflationary policies (Sahap Kavcioglu, 2021-23). 

With the appointment Berat Albayrak (2018-2020), who happened to be the president’s son-in-law and had no policy-making experience, economic policy became also much more interventionist, if not necessarily significantly more expansionary in fiscal terms. Albayrak failed to regain market confidence by a slightly less unorthodox finance minister, Lutfi Elvan (2020-21), whose tenure proved short-lived, likely a reflection of disagreement over the course of economic policy. Ultimately, sustainable policies aimed at maintaining macroeconomic stability were at odds with the president’s political-electoral calculus focused on pump-priming the economy in view of the important 2023 general and even more so presidential elections against the backdrop of the AKP’s and the president’s weakening popularity. 

Exploiting the Phillips curve

In the years following the 2018 elections and the years leading up to 2023 elections, the Turkish government exploited the so-called Phillips curve, which postulates an inverse correlation between unemployment and wage growth (or inflation). Economists are agreed that this inverse relationship only holds in the short term only. If a governments want to continue to exploit this tradeoff in favor of lower employment (and higher economic growth), it needs to raise inflation continuously. This is why political economists recognize the need to establish independent, inflation-righting central banks to limit the ability of elected politicians to exploit the Phillips for short-term electoral benefits at the expense of longer-term economic and financial stability. By replacing several central bank governors, President Erdogan was ultimately able to get his way and force the CBRT into a pro-inflationary, Phillips-curve-exploiting policy shift.

In the run-up to the 2023 elections, inflation reached 85% year-on-year in November 2022. Following his narrow re-election in May 2023, President Erdogan appointed a new economics team led by former minister of finance and deputy prime minister Mehmet Simsek tasked with reducing inflation and stabilizing the economy. Although an inflationary monetary policy had helped maintain high economic growth, high inflation had not only become deeply unpopular, and with no elections, other than the March 2024 municipal elections on the horizon, such a policy shift will have limited financial costs for the president. 

Economic policy focused on rolling back some of the interventionist policies, letting the exchange rate adjust and tightening monetary policy. Thus far, the adjustment has been fairly gradual. The CBRT raised its policy rate just after the elections in June with a modest hike to 15% in the context of 40% year-on-year inflation. It took until March 2024 for the policy rate to reach 50%, but in the meantime inflation had reached 70%, leaving real interest rates in deeply negative territory. Moreover, a minimum wage hike in January 2024 was not exactly conducive to rapid disinflation, either. This suggests that political consideration remain as important as economic ones.

It is difficult to say whether lack of more aggressive adjustment is due to political constraints faced by the economics team or by a conscious decision to avoid a potentially destabilizing “shock therapy” in light of potential financial vulnerabilities in the banking sector. The IMF, for one, has highlighted “high and growing” banking sector risks due to rapid credit growth and weakening of supervision. Equally important, however, is the fact that Turkey’s executive presidency makes economic policy subject to the decision of a powerful president who faces very limited checks-and-balances. More so than before, this makes Turkish economic policy subject to the whims of the president, or this political-electoral calculus. The outlook for the Turkish economy depends on what the authorities do today as well as what they can be expected to do in the future. Quite different from countries other large emerging economies, such as Brazil, Mexico, India or Indonesia with far more robust institutions and greater predictability, Turkey’s policies are more difficult to predict because they are less subject to institutional and political checks-and-balances. On June 4, Turkey’s Constitutional Court invalidated a presidential decree issued in 2018 that authorized the president to sack central bank governors and force the central bank into an inflationary monetary policy. The gradual rebuilding of institutional guardrails around Turkish economic policy would boost domestic and foreign investor confidence and help Turkey exploit its significant economic growth potential in the context of greater economic stability.

Turkey is an example where an increasingly centralized political system and limited checks-and-balances increase policy uncertainty. Political leaders in all political systems are weary of market outcomes over which they have little control as well as independent institutions whose mandates and preferences might run counter to their own political-electoral interests. However, in a political system where power is highly concentrated, this makes economic policy substantially more unpredictable. In less centralized political systems, significant shifts in economic policy can occur when for example a different political party comes to power. But typically it is easier to predict what it will do once in power. It is more difficult to predict policy shifts if power is more highly concentrated and individual decision-makers are highly influential.