Turkey could be in big trouble, but its problems appear political in origin with few systemic implications. From the central bank’s website, it appears that Turkey is dangerously dependent on carry trade flows to finance a trade deficit slightly above 4% of gross domestic product (GDP).

Foreign long- and short-term debt does not appear to have grown at all in the past year, while foreign bank deposits have risen by nearly US $50 billion, about the size of the deficit. If that is so, the situation could get nasty. The carry trade made enormous gains as the lira rose during the year and paid interest rates of around 11%, but these now are under water.

Principal Components Decomposition on MSCI country ETF’s for the period since the beginning of July to present shows that there is a “Turkey factor”:

a.Turkey Factor

That is the 2nd principal component (PC), with a big negative factor loading for Turkey (TURR). Mexico (EWWR), another carry-trade economy, also has a big negative factor loading. Note that the Asians (MCHI, INDA, EWY, THD, EPHE) have positive or only slightly negative loadings, as does Brazil.

Brazil’s stock market is highly correlated (70%) with industrial metals prices over the same period. Mexico depends more on carry trade.

1.Mexico vs Turkey ETF

Mexico and Turkey both are highly correlated with the 2nd PC, but Brazil is almost uncorrelated. We might think of it as a “carry trade risk” factor. This probably is associated with the prospect of Fed tightening.

2.Mexico ETF vs US 10-year yield

The Turkish market implosion appears to be due to a combination of financial pressure on the carry trade and politics.

Turkey’s diplomatic turn towards Iran and Russia is the driver in the diplomatic crisis, although Western countries have long rankled at Erdogan’s brash assertion of Turkish power. Erdogan has made common cause with Iran against the attempt by Iraqi Kurds to form their own state.

In early September, US federal prosecutors charged top Turkish bank executives and a former Turkish economics minister with laundering hundreds of millions of dollars for Iran. The Erdogan government denounced the US and defended its bankers, who include top executives of Halk Bankasi, one of the country’s largest banks.

That is a sharp turnaround from last January, when Washington as well as Moscow wanted Erdogan to succeed. The incoming Trump Administration hoped that a Russian-American deal would stabilize Syria, and that Turkey would act as a counterweight to Iranian ambitions inside Syria.

Washington wanted Turkey to remain inside NATO. The Europeans wanted Erdogan to staunch the flow of refugees (which he had backhandedly encouraged in 2015);  and the Russians wanted his help in neutralizing Sunni jihadists, whom Erdogan had helped off and on. China wanted Turkey to be the western terminus of its One Belt, One Road infrastructure project.

The benign geopolitical backdrop supported the Turkish stock market, which until August 30 was the world’s top performer, up 50% in dollar terms since its January 2017 low point. Erdogan overplayed his hand badly, however. Turkey announced that it would purchase Russia’s S-400 air defense system, a slap in the face to NATO, whose southeastern flank Turkey had guarded since the beginning of the Cold War.

His open alliance with Iran, moreover, destroyed Washington’s hope of establishing a balance of power in Syria. The Syrian Kurds had been the most effective fighting force against Sunni jihadists, and Erdogan now threatens to use the Turkish armed forces against the Kurds.

Erdogan’s dalliance with Iran wrong-footed Washington’s efforts in Syria, and it is not surprising that the first rupture in American-Turkish relations came over Turkey’s covert financial help for Tehran.

Erdogan now finds himself without friends in the West. Turkey has jailed twelve Germans of Turkish descent for alleged involvement in the July 2016 coup attempt, over the strenuous protests of the Berlin government.

Now, Erdogan is getting his “payback,” Holger Zschäpitz writes today in Die Welt. “The collapse of the lira isn’t just a psychological problem for Erdogan. On the contrary, the whole Turkish economy will come under pressure as a result.” Turkish companies have nearly $300 billion in loans denominated in foreign currency, according to central bank data, equal to about a third of total GDP.

The interest burden on these loans rises as the value of the Turkish currency falls. Turkish inflation already is running in double digits.