Opinion | Is Turkey leading world markets to the next crisis?

Turkey’s currency lira is down over 70 percent against the dollar in 2018 and is changing hands at its lowest level ever. The lira has the unenviable distinction of being the weakest currency in the world this year. Last week, it slipped 20 percent, but the currency has been falling for some time now. So, why have global markets, including India, reacted to Turkey’s trouble now?

Before answering that, let’s look at the chain of events in Turkey and why we are at an inflection point.

Not long ago, Turkey was in the same league as India and China and among the fastest growing economies in the world. Though growth was high, the economy was on a weak foundation set up on the ruins of the 2008 financial crisis. Then, developed economies reduced interest rates to prop up growth and some of that liquidity seeped into Turkey. For nearly a decade, Turkish companies and real estate developers have been gobbling cheap foreign debt and bloating their balance sheets.

Turkish banks too were borrowing in dollars to fund the fast-growing domestic economy. With a few companies, let alone economies, showing signs of growth at the turn of the decade, foreign banks were more than happy to feed the Turks.

According to a New York Times report, Turkey relies on foreign-currency debt more than any other major emerging market. Corporate, financial and other foreign currency debt, mostly dollar-denominated, represents about 70 percent of Turkey’s economy.

Data from the Bank for International Settlements (BIS) reveals the extent to which global banks have financed Turkey’s growth. Spanish banks are owed $83.3 billion by Turkish borrowers; French lenders $38.4 billion; banks in Italy $17 billion; Japanese banks $14 billion; UK lenders $19.2 billion; and the United States about $18 billion.

While the US banks may not have financed Turkey, they had more than made up for it by participating in the equity market. US-based investors, according to the International Institute of Finance, hold more than half of Turkey’s publicly traded stocks.

Naturally, a sharp deterioration in the lira will have bankers running for shelter. As the lira loses value, Turkish companies would find it difficult to service their dollar-denominated loans. Reports suggest that many companies in Turkey have said they cannot repay these loans.

The issue now is whether the rout in lira has spread to other currencies. There has been some spillover but not to the extent seen during Greece’s turmoil after the 2008 financial crisis. But Turkey has an economy four times the size of Greece and a population seven times more.

It is up to the Turkish government on how they want to salvage the situation. Unfortunately, it is the government action or rather inaction which seems to be the biggest threat to the economy.

Inflation has already hit 16 percent as compared to around 2 percent in neighbouring Europe. Interest rates have been artificially held at 17.75 percent. With a free-falling currency and rising inflation, central banks turn to interest rates to control both best, as seen in the Russian ruble crisis which helped stall the flight of capital.

However, Turkey’s President Recep Tayyip Erdogan, who won the elections in June, has asked his central bank not to touch interest rates in July. Rather he has made a ‘patriotic appeal’ to his citizens to exchange lira for the dollars they might hold.

Apart from Erdoganomics of talking the lira back to health, Turkey is in US President Donald Trump's line of fire. In a recent tweet, Trump increased duties on Turkey’s steel and aluminium exports to the US which pushed lira further down the hole.

The problem is that Turkey has few options left to prevent the slide. Its overheated economy, which was funded from cheap foreign money, is likely to come crashing down. Economists have lowered its growth from 7.4 percent last year to 4 percent this year.

The country does not have enough foreign exchange reserves to prevent the slide. Turkey has foreign reserves of $130 billion with a short term foreign debt of $180 billion. Of its overall debt of $460 billion, 70 percent is foreign. If the flight of capital is not staunched, the scenario will turn from bad to worse. However, capital controls have historically worked only to a limited extent and the only option is raising interest rates.

Thankfully, the contagion has not majorly spread to other nations, even though sentiment has been affected with money being withdrawn from emerging markets. Change in sentiment is a big threat for India as the country is already running a high current account deficit and risks fiscal slippages in an election year. Indian policymakers would do well to focus on macro-economic stability, especially when the US Federal Reserve is in no mood of delaying hiking interest rates.

Turkey is small in the overall global economy, but Greece was smaller and it rattled the world. Thailand was even smaller, but it was enough to trigger the Asian currency crisis of 1997.

Sooner or later Erdogan will have to throw in the towel and ask for international monetary help. The more he delays, higher is the chance of a spillover.