Meltdown in Turkey

A man counts Turkish lira in Istanbul, Turkey, on Aug. 14, 2018. [Photo/Xinhua]

The Turkish currency, the lira, is in meltdown. It has lost 40 percent of its value against the dollar in the last six months and fell nearly 20 percent in recent days. President Erdogan, recently re-elected as the country's leader, has pursued erratic economic policies throughout his tenure and these are now coming home to roost.

However, the immediate crisis erupted when the U.S. froze the assets of Turkey's justice and interior ministers, for their alleged role in the detention of Andrew Brunson, an American pastor. Mr Brunson, who ran a small church in Turkey for two decades, was arrested in October 2016, and accused of participating in a conspiracy to topple Mr Erdogan, a charge he denies.

Turkish and U.S. interests also clash on a wide range of issues from Syria to the delivery of U.S. arms.

On August 10, U.S. Commerce Secretary Wilbur Ross hiked tariffs on Turkish steel imports to 50 percent, claiming that the previous level of 25 percent had failed to reduce Turkish exports to the U.S. "Doubling the tariff on imports of steel from Turkey will further reduce these imports that the [commerce] department found threaten to impair national security," Ross said.

This was the trigger exposing the fast deteriorating economic situation. After a failed military coup against Erdogan in 2016, he encouraged a credit boom to boost the economy, while incarcerating thousands of "opponents." Many academics and civil servant suspected of hostility to Erdogan were sacked.

He kept interest rates low and blocked action by Turkey's central bank to curb spiraling inflation, describing interest rates as "the mother and father of all evil."

Turkey's economy could not cope, while, at the same time, the U.S. Federal Reserve began to raise U.S. interest rates and the U.S. dollar gained further strength. Turkey is a country without energy resources and the vast majority of funding for its industrial development, construction and real estate comes from abroad, mainly from American and European investors. At the same time, citizens and companies commonly take out their loans in dollars and euros.

What appeared to be fast economic growth in the last two years was built on credit and foreign borrowing. Imports flooded in, but were not matched by exports, and the profitability of Turkish capital fell sharply. The rise of the dollar and interest rates globally brought an end to the party and exposed the real situation.

Turkey's banks and corporations are now in dire straits. The foreign currency liabilities of non-financial companies now outstrip their foreign exchange assets by more than $200 billion.

The country's banks and corporations have billions of dollars of hard-currency debt falling due. The banks are scheduled to repay $51 billion over the next year, while the remaining $18.5 billion sits in non-financial corporate balance sheets. These bills are payable at a time when corporate indebtedness is 62 percent of GDP, half of which is denominated in foreign currencies.

Foreign investors are now worried that Turkey will not be able to pay. Relative to its short-term external debt, its foreign exchange reserves have fallen dramatically. So, capital fled the country and the lira tumbled.

If Turkey's banks and corporations start defaulting on their debt servicing, European banks could suffer significant losses to their own balance sheets, what markets call "contagion" – the spread of losses and default internationally.

Some of Turkey's banks are foreign-owned and the biggest lenders to Turkey are Spain's BBVA, Italy's UniCredit and France's BNP Paribas. Turkey's banks appear to have plenty of reserves, and loans to Turkey are just a small part of the total loans made by these foreign banks. Nevertheless such "marginal" losses can be a tipping point when profits are tight.

Can Erdogan overcome this currency crash? The "normal" solution is to hike interest rates to an astronomical level so that further borrowing is stopped. Then, the government should dramatically cut government spending and raise taxes, i.e. fiscal austerity, and use the "savings" to bolster the banks and meet foreign debt repayments.

Turkey could turn to the IMF for a loan – Greek style. Under IMF rules, it could borrow up to $28 billion to fund future debt repayments, but this would result in IMF imposed austerity measures. This solution would produce an outright slump in the Turkish economy, hitting its citizens hard and seriously undermining Erdogan's support in the country.

The government could introduce capital controls and block money leaving the country. But foreign lenders would stop lending, driving the economy into a slump.

Erdogan could try to get funding from Russia, China or Saudi Arabia (as Pakistan has just done). However, he is on bad terms with all these countries. Erdogan is resisting all these options so far, telling his supporters to "trust in God," which is hardly a formula that works. Similar crises are brewing in Argentina, South Africa and Ukraine.