Breaking Turkish economy’s vicious circle will be painful

Turkey’s lira remains perched on the precipice of 4.5 to the dollar. It was trading just short of that key psychological level this morning at 4.482 to the dollar. The battered currency briefly touched 4.5 earlier this week before Turkey’s central bank announced that it would do anything necessary to protect the currency.

The market and the central bank now stand opposite each other like spaghetti-western gunfighters. What Turkey requires is a devaluation of the lira sufficient to bring in foreign capital. That implies a lot of corporate bankruptcies and a sharp recession, because the cost of servicing Turkey’s US$300 billion in foreign corporate debt rises as the lira falls. Some Turkish companies, to be sure, have foreign earnings with which to pay foreign-currency debt, but overall, Turkey is running a current account deficit at 6% of GDP, which means that foreign corporate borrowing has been financing an excess of imports.

Turkey is in a vicious circle. It needs to build up domestic capacity to replace imports, and build up export capacity, but to do so, it has to import capital and spend more to train a largely unskilled, poorly educated workforce. But capital is fleeing rather than arriving, which means that the path to recovery lies through the carnage of corporate reorganization.

The Istanbul 100 index is now trading with a price-earnings ratio of below 7, which makes it the cheapest large stock market in the world apart from Russia. That is cheap but not nearly cheap enough. During the 2008 crisis Turkey’s P/E ratio fell to around 4. Global financial conditions, to be sure, were much worse, but Turkey’s debt situation back then was much better. After a decade of debt-bubble formation on the Erdogan model, Turkey requires more of a shakeout.

Asia Unhedged wouldn’t buy Turkish stocks until the carnage is over, and the carnage might be literal: Erdogan has backed himself into a corner economically, while bottling up political opposition through mass arrests, sham trials, press censorship and (in the case of the Kurdish-majority south) military assault. In short, the Turkish market is cheap for a reason. It’s not a time to catch the falling scimitar.