How serious is Turkey’s crisis?

Bad and getting worse by the day. Over the past five years, Turkey’s growth has been virtually keeping pace with that of China and India but it is now displaying the classic signs of overheating: a large trade deficit, a construction boom and soaring debt. Financial markets have taken fright at inflation, rising at an annual rate of more than 15%, and have been selling the Turkish lira, which is down by 45% against the US dollar since the start of the year.

Two additional factors are exacerbating the crisis. Turkey’s president, Recep Tayyip Erdoğan, is opposed to raising interest rates to cool down the economy and support the currency and has used his recent election victory to impose his unorthodox views on the country’s central bank. The lack of interest-rate action has coincided with a marked worsening of Turkey’s relations with the US. Turkey’s decision to hold an American pastor, Andrew Brunson, under house arrest on disputed terrorism charges, has prompted Donald Trump to impose sanctions and double tariffs on imports of Turkish steel and aluminium.

What are the implications for the global economy?

The direct impact of what looks like an inevitable recession in Turkey would be relatively small because, despite a population of 80 million and strong growth in recent years, the country accounts for only 1% of global GDP. Eurozone countries run a trade surplus with Turkey but it is small. In the two previous Turkish financial crises since the turn of the millennium, European exporters have been able to divert their business to other markets. The European Central Bank has expressed concern about potential contagion through the eurozone banking system, with Spain, followed by Italy, the most heavily exposed countries.

A bigger danger is that Turkey’s crisis will spill over into other emerging market economies and there were signs on Monday that other countries seen as vulnerable were coming under speculative attack. Turkey’s problems are particularly acute because it has more than $300bn of dollar-denominated corporate debt, which is getting more expensive to finance by the day. However, other countries – such as Mexico and South Africa - also took advantage of low US interest rates in the years after the financial crisis to borrow heavily in dollars and saw their currencies coming under pressure. The fear is of a full-blown emerging market crisis.

What are the geopolitical implications?

Since the second world war, Turkey has gravitated to the west. It has been a member of Nato since 1952; in 1987 it applied to join what later became the European Union and prided itself in being a secular democratic state. But there has been a marked shift under Erdoğan. Accession talks with the EU have been suspended in response to alleged human rights and rule of law abuses; Washington has said Ankara’s decision to buy Russian S-400 missiles was incompatible with Nato’s defence systems; and Erdoğan has supported the Islamisation of Turkey.

Lira crisis: action by Turkey's central bank fails to quell contagion fears Read more

The Turkish president’s standoff with Trump has fuelled concerns of a foreign policy shift that would result in Turkey leaving Nato, forging stronger political links with Russia, China and Iran, and allowing the three million Syrian refugees living in Turkey to leave for the EU. But none of these long-term decisions will resolve Turkey’s immediate problems.

So what can the Turkish government do?

For the time being, the government’s response has been to talk tough but to do very little. Erdoğan has accused the US of stabbing Turkey in the back, the government has announced a crackdown on those on social media spreading fake news about the crisis and the central bank has eased financing requirements for Turkish banks.

None of this looks remotely sufficient to deal with the scale of the crisis, particularly given the paucity of Turkey’s foreign currency and gold reserves – which are often used by central banks to fight off currency speculators. Erdoğan has insisted that Turkey remains committed to the principles of an open market economy but one option for the government is to try capital controls as a way of taking pressure off the lira. This might provide a breathing space but probably only a temporary one, given that Turkey is an open economy and has large foreign currency needs.

What happens next?

The history of previous emerging market crises suggests there is only one likely winner in the battle between Turkey and the currency speculators. In the current circumstances, only two things will halt the lira sell-off: a substantial rise in official interest rates (already above 17%) or the announcement of an emergency package of financial support from the International Monetary Fund – or, if things continue to deteriorate, both together. Freeing Brunson would also help. All this would be a grave embarrassment for Erdoğan, one of the world’s self-styled strongman leaders, but there are no easy options available. The issue is not whether Turkey is heading for recession, but just how deep the recession will be.