The Turkish emerging market time bomb

LONDON — Turkey’s falling currency and deteriorating financial conditions lend credence, at least for some people, to the notion that “a crisis is a terrible thing to waste”. I suspect that many Western policymakers, in particular, are not entirely unhappy about Turkey’s plight.

To veteran economic observers, Turkey’s troubles are almost a textbook case of an emerging-market flop. It is August, after all, and back in the 1990s, one could barely go a single year without some kind of financial crisis striking in the dog days of summer.

But more to the point, Turkey has a large, persistent current-account deficit and a belligerent leader who does not realise or refuses to acknowledge, that his populist economic policies are unsustainable. Moreover, Turkey has become increasingly dependent on overseas investors, and probably some wealthy domestic investors, too.

Given these slowly gestating factors, markets have long assumed that Turkey was headed for a currency crisis. In fact, such worries were widespread as far back as the fall of 2013, when I was in Istanbul interviewing business and financial leaders for a BBC Radio series on emerging economies. At that time, markets were beginning to fear that monetary-policy normalisation and an end to quantitative easing in the United States would have dire consequences globally. The Turkish lira has been flirting with disaster ever since.

Now that the crisis has finally come to pass, it is Turkey’s population that will bear the brunt of it. The country must drastically tighten its domestic monetary policy, curtail foreign borrowing and prepare for the likelihood of a full-blown economic recession, during which time domestic saving will slowly have to be rebuilt.

Turkish President Recep Tayyip Erdogan’s leadership will both complicate matters and give Turkey some leverage. Erdogan has steadily been seizing constitutional powers, reducing those of the parliament, and undercutting the independence of monetary and fiscal policymaking. And to top it off, he seems to be revelling in an escalating feud with US President Donald Trump’s administration over Turkey’s imprisonment of an American pastor and purchase of a Russian S-400 missile-defence system.

This is a dangerous brew for the leader of an emerging economy to imbibe, particularly when the United States itself has embarked on a Ronald Reagan-style fiscal expansion that has pushed the US Federal Reserve to raise interest rates faster than it would have otherwise. Given the unlikelihood of some external source of funding emerging, Erdogan will eventually have to back down on some of his unorthodox policies. My guess is that we will see a return to a more conventional monetary policy and possibly a new fiscal-policy framework.

As for Turkey’s leverage in the current crisis, it is worth remembering that the country has a large and youthful population, and thus the potential to grow into a much larger economy in the future. It also enjoys a privileged geographic position at the crossroads of Europe, the Middle East and Central Asia, which means that many major players have a stake in ensuring its stability. Indeed, many Europeans still hold out hope that Turkey will embrace Western-style capitalism, despite the damage that Erdogan has done to the country’s European Union accession bid.

Among the regional powers, Russia is sometimes mentioned as a potential saviour for Turkey. There is no doubt that Russian President Vladimir Putin would love to use Turkey’s crisis to pull it even further away from its NATO allies. But Erdogan and his advisers would be deeply mistaken to think that Russia can fill Turkey’s financial void. A Kremlin intervention would do little for Turkey, and would likely exacerbate Russia’s own financial and economic challenges.

The other two potential patrons are Qatar and, of course, China. But while Qatar, one of Turkey’s closest Gulf allies, could provide financial aid, it does not ultimately have the wherewithal to pull Turkey out of its crisis single-handedly.

As for China, though it will not want to waste the opportunity to increase its influence vis-à-vis Turkey, it is not the country’s style to step into such a volatile situation, much less assume responsibility for solving the problem. The more likely outcome, as we are seeing in Greece, is that China will unleash its companies to pursue investment opportunities after the dust settles.

That means that Turkey’s economic salvation lies with its conventional Western allies: The US and the EU, particularly France and Germany. On August 13, a White House spokesperson confirmed that the Trump administration is watching the financial-market response to Turkey’s crisis “very closely”. The last thing that Trump wants is a crumbling world economy and a massive dollar rally, which could derail his domestic economic ambitions. So a classic Trump “trade” is probably there for Erdogan, if he is willing to come to the negotiating table.

Likewise, some of Europe’s biggest and most fragile banks have significant exposure to Turkey. Combine that with the ongoing political crisis over migration and you have a recipe for deeper destabilisation within the EU. I, for one, cannot imagine that European leaders will sit by and do nothing while Turkey implodes on their border.

Despite his escalating rhetoric, Erdogan may soon find that he has little choice but to abandon his isolationist and antagonistic policies of the last few years. If he does, many investors may look back next year and wish that they had snapped up a few lira when they had the chance.

Jim O’Neill, a former chairman of Goldman Sachs Asset Management and a former UK treasury minister, is chair of Chatham House. Copyright: Project Syndicate, 2018.
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