Turkish President Erdogan claims to have launched an 'economic war of independence' against markets that have bombarded his nation's currency. Image: Twitter

In crisis since 2018, Turkey’s national currency has careened to record lows in the past ten days with no end to the turbulence in sight.

The Turkish lira dropped to 8.40 to the US dollar on Monday (November 2) following an unprecedented dip to 8 on October 22. The currency has lost 40% of its value since the start of 2020, with more than 7% lost in the past month.

The main question now is whether Turkey’s prolonged currency crisis will turn into a debt crisis, as foreign reserves dwindle and foreign direct investment (FDI) stagnates.

The share of private external debt in Turkey’s total gross external debt is down from 70% in 2015 to 56.6% in the second quarter of 2020. This comes as the private sector deleverages to minimize exchange rate risk, a trend which began in 2015 but has sped up in the past two years of crisis.

International financial markets still seem to be willing to lend to Turkey but not in Turkish lira even though Turkey offers generous interest rates on its Turkish lira bonds. The public sector has increasingly borrowed from international markets, taking the public share in the total gross external debt to 43%. This is 11 percentage points higher than it was in 2018.

The phenomenon of public sector borrowing in foreign currency, even from domestic financial markets, carries exchange rate risks into domestic debt instruments, which are showing signs of the worsening conditions of Turkey’s financial system.

This may present an even more critical problem under Covid-19 conditions, in which tax revenues in Turkish lira are narrowing while the currency continues to depreciate.

The question of whether Turkey will face a debt crisis will thus likely hinge on whether international markets will continue lending given the increasingly higher costs, and whether Turkey can attract fresh foreign capital for its companies.

The ‘devil’s triangle’

President Recep Tayyip Erdogan, speaking at a rally of supporters on October 31, said Turkey was up against an economic “devil’s triangle” comprised of interest rates, inflation and exchange rates.

“Our response to those who work to besiege our country in the economic sphere is a new war of economic liberation,” he said in comments reported by Bloomberg.

In recent days, the Turkish leader has called for a boycott of French goods and insulted French President Emmanuel Macron several times. Yet his government also is counting on fresh foreign capital to get the economy back on track, most of which would be expected to come from the European Union – Turkey’s top trading partner.

Erdogan’s son-in-law and Minister of Economic Affairs Berat Albayrak has promised a new wave of capital inflows in the near future. Given the depreciation of Turkish assets, if not now, when can Turkey attract foreign direct capital inflows?

The nationalistic Erdogan government hopes to attract international buyers to come and acquire Turkish companies on the cheap and salvage them. But so far, they are not biting.

Annual FDI inflows into Turkey, discounting estate investments, were negative in August, following a declining trend since the end of 2015. More worryingly, US$4.5 billion in net capital outflows were recorded in the first eight months of 2020, according to the Balance of Payment statistics of the Central Bank of Turkey, suggesting massive capital flight.

With high external debt, structural current account deficits (particularly during times of growth), and the rise of non-tradable sectors funded through pro-government capital groups, the economy can only persist as long as foreign capital inflows continue.

With those drying up and slowing down, the economy is contracting. That means the public budget and state banks have been compelled to take the lead in reviving the economy. Chronically high unemployment and inflation have been the main symptoms of these economic problems.

Zombie companies

Since the summer 2018, the Erdogan government has extensively used the public budget, but in particular the public banks, to avert the bankruptcy of private companies and indebted households.

This publicly induced Ponzi scheme led to the creation of so-called “zombie” companies, which have slowly transferred private debt into public debt, hiding the severity of underlying economic and financial problems.

During the Covid-19 pandemic, instead of providing public funds to private companies and households which were affected negatively by a lockdown, the Erdogan government offered cheap credits via public banks and coerced the private banks to loan more, embedding the Ponzi scheme into the pandemic response and risking the health of the financial system.

Thanks to this policy, Turkey’s gross external debt stood rose to 57% of GDP by the second quarter of 2020. Meanwhile, the ratio of gross international reserves to short-term external debt – an indicator of financial vulnerability – dropped to 46.2% in August, its lowest level since 2011, according to Ministry of Finance and Central Bank statistics.

Moreover, the total internal and external debt-to-GDP ratio, excluding the financial sector, now tops 130% of GDP.

The Turkish lira in free fall in a conceptual image. Photo: iStock

To continue providing cheap credit to the private sector, Turkey must keep interest rates low. To keep interest rates low, the value of the Turkish lira has to be propped up to a reasonable level.

This goal has compelled the authorities to employ unorthodox measures, ranging from drying up Turkish lira liquidity in internal and international markets, to taxing foreign exchange transactions, to selling US dollars implicitly via public banks – thereby eating into international reserves.

As a result of this shell game saga, net international reserves without swaps held by the Central Bank of Turkey was estimated at negative $16.9 billion in August 2020.

With Turkey having reached the end of yet another publicly fueled credit expansion, and faced with negative international reserves, the Central Bank has no other option left but to raise interest rates – a move abhorred by Erdogan.

To balance expectations, the Central Bank late last month raised interest rates obliquely by not touching the policy rate, as it initially did in 2018 before reversing course. It kept its main policy rate intact and increased its Late Liquidity Window (LON) to 14.75% on October 23. International markets had expected an at least 500 base rate hike.

The record depreciation of the Turkish lira in the wake of that announcement makes clear that a limited, implicit intervention in interest rates will not be enough to stabilize the troubled currency, given its accumulated fragility and vulnerabilities.

Turkish President Recep Tayyip Erdogan faces crisis at every turn. Photo: AFP/Ramil Sitdikov/Sputnik

Yet higher interest rates will not solve Turkey’s problems in the medium or long term.

For the past two decades, Erdogan has presided over a debt-driven economic model dependent on cheap foreign credit. His political party has consistently blamed enemies – either internal or external, real or imagined – for the country’s economic problems, always postponing hard measures to avert political costs.

By failing to address structural problems, Erdogan is setting Turkey up for another currency and possible debt crisis. At the same time, he has embroiled Turkey in multiple international adventures, from the South Caucasus to calling for a boycott of France. The bills for both will eventually come due, perhaps sooner than the war-fighting leader realizes.