Since the crisis in Turkey seems to be reaching a critical phase, I want to write a separate post on it, apart from the daily commentary. Now, if you read my post on Turkey from a month ago, you can see my worry was the emerging markets universe. But now, the contagion has spread to Europe in terms of bank holdings of Turkish assets. So this opens another area of potential contagion from the crisis in Turkey.
The political dimensions
Since this crisis is as much political as it is economic, let me mention a few threads that are creating the tension. The first is the rapprochement of Turkey and Russia. From a NATO perspective, because Turkey intersects Europe and Asia and is a gateway to the Middle East, it is seen as a key defense against Russian expansion and a bulwark against turmoil in the Middle East.
But now, Erdoğan is buying Russian missiles for its arsenal rather than American missiles. That is a key point of friction with the US. And Turkey and the US are constantly at odds over the US alliance with Kurdish groups in the war in Syria because they see those groups as threatening for Turkey.
So, the sanctions the US has imposed because of the American Pastor has this as background, meaning the Pastor may be a pretext to try and bring Turkey to heel in a wider context.
And let’s not forget the tension with Europe over Turkish accession to the EU, human rights in Turkey and refugees from Syria. In the wake of the attempted coup in 2016, Erdoğan did not feel he got any support from his European NATO allies. And when he crushed dissent and imposed martial law, the Europeans criticized him for state repression. So, there is no love lost between Erdoğan and the EU.
At the same time, Turkey is the only thing between hundreds of thousands of refugees from the war in Syria and the EU. So keeping Turkey onside is not just beneficial for the EU because Turkey is ally of many EU nations that are in NATO.
The governance issues
With a difficult political backdrop, the governance issues in Turkey make the situation worrying. In fact, I would point to governance as the critical problem fuelling the crisis. After the recent elections in Turkey, Erdoğan ’s own son-in-law Berat Albayrak replaced Mehmet Şimşek as finance minister. And while Albayrak is considered western-friendly, it’s clear this is just a case of nepotism. He’s not going to defy Erdoğan.
Erdoğan has said the crisis is just an attack on Turkey by the West, his ostensible NATO allies. He doesn’t cop to any blame himself. And as such, he is loathe to do what’s required to right the ship.
Just today, the Turkish lira dropped as far as a record low of 7.2 against the US dollar. This compares to 4.28 three months ago, 3.54 a year ago, 2.76 three years ago and 1.92 five years ago. That’s a catastrophic level of depreciation in a country where much of the external debt is in dollars or euros.
Yet, addressing the Ambassador’s conference today, Erdoğan laid all of the blame on Trump, accusing him of breaking WTO principles, of backstabbing and of shooting its partner in the foot with sanctions. Here’s one exact quote:
the bullies of the global system cannot roughly, shamelessly encroach on our gains that were paid for by blood.
But according to Reuters, although Erdoğan said he expected the attacks on Turkey’s to continue, he predicted the lira would return to “rational levels” soon.
On what basis?
In a statement (online here), the Turkish central bank says:
The Central Bank will closely monitor the market depth and price formations, and take all necessary measures to maintain financial stability, if deemed necessary.
That won’t work. What Turkey needs now is interest rate hikes and a loan from the IMF, which would come with harsh pre-conditions. But they are doing neither. And I suspect they won’t do either anytime soon.
Outcomes
This is looking bleak right now, frankly.
The central bank has days to stop the currency freefall before we see defaults. And since it won’t do what it needs to do – i.e. raise rates – to stop the freefall, expect the lira to continue down, despite being severely undervalued already.
If and when we get defaults, that’s when Turkey’s financial system comes under stress. And it is also when we see a spillover into European banks, the new worry from markets.
The Guardian has this chart up, showing exposure by country to Turkey’s debt.
These are the kind of charts we saw regularly during the European sovereign debt crisis.
What could Erdoğan do next to stem the tide?
- He could impose capital controls to prevent money from flooding out. He has been encouraging citizens to do their patriotic duty and buy lira and sell foreign currencies to prop up the lira. That won’t work. And people with foreign currency will be panicked. So capital controls are likely.
- Erdoğan could also forcibly convert bank accounts from US dollars or euros into lira. In Argentina, they did this during their crisis some years ago. And while this would be ineffective in preventing the currency from continuing its freefall, it is not inconceivable that this is a measure the government would take.
What could Erdoğan do to apply pressure politically?
- Turkey has 3 million Syrian refugees. Many of them would prefer the EU to Turkey. All Erdoğan needs to do is allow many of them to make their way to the EU and that would apply some political pressure.
- Erdoğan could also threaten to quit NATO altogether for a relationship with Russia. Given Turkey’s critical role in the Middle East, that would be a disaster for NATO.
I don’t see Erdoğan caving though. So over the next several days, we will likely get a more intense crisis in Turkey.