Justin Vela in Istanbul -

The results of an emergency meeting called by Turkey's central bank on August 4 increased concerns over the country's economic policies and pushed the already depreciating lira lower. Turkey's government will have to follow up with clear reforms to convince observers that its policies are aimed at more than pleasing an overspending public.

Central bank officials chose to reduce the benchmark interest rate to an all-time low of 5.75% from 6.25%. The move, which aims to increase domestic economic activity, highlights the central bank's worries that another global crisis will soon affect Turkey, despite claims from members of the ruling Justice and Development Party (AKP) that it won't. "The crisis in Europe will not even touch us and will pass this time," Turkish Prime Minister Recep Tayyip Erdogan was quoted as saying by Today's Zaman on July 27.

Citigroup's Ilker Domac said in an e-mailed note that, "Once again, the bank has caught the markets off guard by cutting its policy rate when such a move was seen as difficult to justify." Cutting rates when the lira is already falling and inflation increasing does not bode well for financial stability, nor was there a decline in domestic economic activity to support the cut, Domac said.

Aiming to counter the lira's fall, the central bank also raised its overnight borrowing rate to 5% from 1.5%, according to a statement, and will begin daily auctions of foreign currency to keep markets liquid. Yet immediately following the meeting, the lira fell about 2% to TRY1.74 against the dollar, according to Reuters. Since the beginning of the year, the currency has depreciated by about 12.6%, making it one of the worst performing emerging market currencies.

Domestic vs. international concerns

There is little argument that the Turkish economy needs to make adjustments to correct rampant growth. Having seen their GDP rise 11% on year in the first quarter of 2011, credit-happy Turks are spending wildly, feeding an unhealthy demand for imports as exports underperform. This is causing a widening of the current account deficit.

However, the decision to cut interest rates was a surprise. For one, the central bank was not expected to make any changes to its already controversial policy of low interest rates anytime soon. The economy also needs to slow in order to dampen the overheating and narrow the current account deficit, which was singled out by Moody's Investors Service this month as one of the reasons why Turkey remains under investment-grade status. "It is important for the Turkish economy to slow down this year and next," says Emre Deliveli, a freelance consultant and economics columnist.

Growth for this year is expected to be about 8%. Raising interest rates instead of cutting them would assist in slowing the economy more quickly. "[Hiking interest rates] would slow down demand, but will also be useful to attract capital into the country and make the lira appreciate if the foreign capital flows dry up," says Deliveli.

The current account deficit is now financed largely by short-term capital flows from portfolio investors, with net foreign direct investment covering only 15%.

Deliveli puts responsibility for the low interest rate policy squarely on the shoulders of PM Erdogan. "The increasing of interests rates is against the wishes of the prime minister," he claims.

Crunch time

The ruling AKP claims Turkey will stand among the world's top 10 economies by 2023, the centennial anniversary of the Turkish Republic. Over the past eight years, the party's management of the economy has turned Turkey into an economic powerhouse. But the government's obsession with high growth numbers as supposed to restructuring the economy puts Turkey in a precarious position, say experts.

Profits are currently high enough that most companies and individuals are satisfied with the status quo. But adjustments must be made to the structure of Turkey's economy or the country will continue to face long-term uncertainty regarding stability, remain below investment-grade status, and viewed as susceptible to outside instability. Hardly the place long-term foreign direct investment would like to settle in.

There is much that the government and the central bank, whose independence is increasingly being quested, can do. In September, a new medium-term economic plan will be established. According to analysts, the goal should be to slowly depreciate the lira to a suitable level and slow the economy for the next two years, narrowing the current account deficit and reducing the risk of overheating and asset bubbles. Then the economy will be brought back to what most economists believe is a sustainable growth rate of about 6-8% per year.

The plan must also focus on making the necessary micro-economic reforms. Labour markets must be more flexible, there is a massive grey economy, women's labour force participation is very low and there's a need for a regional minimum wage similar to that in the US. Domestic production must be boosted.

Crucially, even Erdogan addressed one of the most important changes that must be made when he encouraged Turks to save money during a July press conference

This makes the interest rate drop all the more curious. Is asking Turks to save while encouraging them to spend not contradictory policy in Turkey?