The meltdown in the Turkish lira filled the news this past week, but for good reason. Turkey is in a war with the financial markets and with President Trump and it is likely to lose both battles. That’s what happens when a country ignores the economic consequences of its actions. Large fiscal expenditures financed with dollar and euro loans made the country highly vulnerable to the credit markets to provide financing. The international politics was just icing on that cake.
Turkish President Erdogan spent lavishly to promote rapid development. And the country’s banks and businesses picked up on the cue and borrowed heavily to finance waves of new construction. The Turkish economy boomed, its debt soared, and inflation rose sharply. But that debt was mostly denominated in dollars and euros, so when the Turkish lira fell sharply in value, reflecting flight out of the currency, the debt increased dramatically in lira terms. With the lira falling by nearly 50% against the U.S. dollar, the cost of servicing that debt nearly doubled for Turkish borrowers. Few countries can handle a doubling in its debt burden in such a short period of time.
But Turkey’s approach defies economics. Erdogan essentially instructed the central bank to keep interest rates low. The President also appointed his son-in-law as Finance Minister. Is it any wonder the market panicked? This is in keeping with King Canute’s inability to keep the tide from rolling in.
The situation was exacerbated needlessly by Erdogan’s conflict with the U.S. over President Trump’s demand for the release of a pastor imprisoned by Erdogan for the last two years. An agreement was apparently reached whereby Israel would release a Turkish citizen from prison in exchange for Turkey releasing the pastor. After Israel released the Turk, Erdogan did release the pastor from prison, but placed him under house arrest, effectively violating the deal. The market panicked at Erdogan’s behavior and the lira was cooked.
The only good news in this story is that bankruptcies across Turkey, which are certainly coming, will have little effect on Europe, which owns most of the foreign currency loans, and even less of an effect on the U.S. economy. The U.S. owns little of that Turkish debt and has relatively modest trade flows with Turkey. So expect the financial news out of Turkey to worsen and for that to remain headline news, but aside from conjuring up some fears, there should be little impact on our economy and only temporary dips in our markets.