The currency markets seem to have given the Turkish Lira a temporary respite. But the underlying problems remain the same: an unsustainable current account deficit; excessive dependence on foreign currency denominated (especially dollar denominated) debt; and high inflation. While the markets demand a radical hike in interest rates, President Erdogan fears this would tip the economy into inflation, and undermine the popular support essential to his authoritarian government. The sharp fiscal cuts promised by his son-in-law (the newly appointed Central Bank Governor) would probably have the same effect, which is why they probably won´t happen.
Western analysts and the Trump administration are keen to blame Turkey for its economic woes, but the real culprit is loose western monetary policy after the 2007-8 financial crisis. Western central banks drove interest rates down to the zero lower bound. When that proved insufficient to stimulate their economies, they began printing money (quantitative easing – QE – a term that conveniently dissimulated what the central banks were doing). With such an unappealing interest rate environment in the US and Europe, investors sought more interesting opportunities for the money creates by QE in emerging markets. Emerging markets like Turkey were suddenly flooded with portfolio investment at low interest rates. This sudden influx of foreign portfolio investment into their capital accounts inevitably drove deficits in their current accounts, as well as inflation and bubbles in asset prices. It was equally inevitable that as western central banks sought to “normalise” monetary policy, by withdrawing QE and raising interest rates, this would cause problems for emerging markets like Turkey. They would now be confronted by the challenge of financing their current account deficit and their dollar denominated debt in an environment of reduced international liquidity, a strengthening dollar and rising interest rates.
The specific catalyst for Turkey´s current crisis has been the confrontation with the US over the detention of an American pastor, whom Turkey accuses of terrorism and espionage. Hostage to the evangelical right (whose support was crucial to his election as President), President Trump has imposed punitive tariffs on some Turkish products. Erdogan has defiantly imposed his own tariffs on US products, imposing threats of further retaliation from Washington. Politically it will be difficult for either president, both of authoritarian instinct, to step down. Further escalation can be expected, with further consequent deterioration in the Turkish economy.
The confrontation with Washington forms part of a progressive geopolitical re-positioning of Turkey since the 2016 failed coup d´etat away from the West and towards Russia. There are various reasons for this. Erdogan is angered that, after much prevarication, it is clear that Turkey will never join the EU. European criticism of his human rights record has added salt to the wound. US withdrawal from the Middle East leaves Turkey lacking regional strategic partners, exacerbated by the US support for Kurdish groups which Ankara sees as terrorist groups linked to the PKK inside Turkey. Comparing Russian decisiveness in Syria with US vacillation, Erdogan appears to have decided that Moscow could be a more reliable partner, for the time being at least. Putin undoubtedly will not criticise Erdogan´s human rights record, and will support further moves towards an authoritarian. Moving closer to Russia also means moving closer to China, while Turkey has been able to secure short term financial support from Qatar.
Merkel rang Erdogan this week to assure him of Europe´s support (more moral than real, as ever) in confronting the crisis. She had good reason to do so. The progressive geopolitical alienation of Turkey poses the German chancellor a series of problems. She fears that Turkey could renege on the agreement which has radically reduced the flow of migrants from Turkey into the EU. This could prove existential both for the EU and Merkel. She fears contagion of a Turkish financial crisis into the Eurozone, especially through the exposure of Spanish, Italian and French banks. She knows that the failure to reform the Euro means that the Eurozone is in no state to confront a new financial crisis. Finally she is concerned about the implications for NATO. It is questionable whether Turkey, with its ever closer relations with Moscow (including an agreement to buy Russian weapons systems), can still be considered a reliable NATO ally. But that means that NATO can no longer rely on its second largest army. With doubts about Trump´s commitment to Article 5 of the North Atlantic Treaty (the commitment to mutual defence), the deficiencies of European defence and security would be thrown into even sharper relief, together with the low levels of preparedness of German armed forces.
The specific geopolitical confrontation which has served as the catalyst for the current financial crisis in Turkey are recent. However, the underlying economic and financial realities are long term and result from western monetary policy. As is the volatile and dangerous geopolitical environment in which Turkey exists. Foreign investors, including major European banks, should have given more careful thought to the monetary and geopolitical factors, rather than just looking at superficial micro economic data, before making their investment decisions. Turkey has escaped the immediate crisis, but is not out of the woods. As long as western monetary policy continues to tighten, all emerging markets like Turkey will suffer. Turkey´s immediate geopolitical environment will make it worse.