A Crisis Waiting To Happen

What happened?

Standard & Poor’s, the credit-rating agency, downgraded Turkey’s sovereign credit rating into ‘junk territory’. It expects further currency volatilities and forecasts a recession for next year. Since the beginning of the year, Turkey’s Lira has dropped 40% in value against the US Dollar. This is the result of:

1. Failed efforts by the central bank to curb inflation
2. Turkey’s vulnerability to declines in global liquidity
3. The country’s diplomatic dispute with the US

Why does it matter?

The time of cheap money is running up. Central banks across the world are gradually tightening the reins. Capital becomes scarcer and more expensive. This negatively affects countries, such as Turkey, that are highly dependent upon foreign capital. Erdogan financed his massive infrastructure projects (that drove the economy for a good time) with foreign capital.

Turkey’s currency reserves further dropped below its short-term foreign debt levels. More so, Turkey has had for years a trade deficit. Foreign debt and trade deficits are per se not toxic. Yet they need to be financed with steady capital inflows. Because of Erdogan’s policies and the globally decreasing liquidity, this influx has faltered.

What’s next?

The need for reforms is high in Turkey. Thailand could serve as an example. In the aftermath of the East Asian Financial Crisis of 1997, the country fundamentally reformed itself. Nowadays, it has a trade surplus of 10% of its GDP. The ratio of currency reserves to short-term debt stands at 3:1. The upside of these developments could be seen last week. While various emerging markets’ currencies suffered, the Thai Baht remained stable.

As of now, it doesn’t look like a contagion risk for emerging markets. We are rather dealing with price-adjustments for risk.

The Turkish government would be well advised to:

1. Raise interest rates
2. De-escalate tensions with the US
3. Sign an external funding agreement with the IMF

Since these measures will come with explicit and implicit costs, it seems unlikely that Erdogan will push for any of these soon.

© Photo: https://www.politico.com/story/2017/11/24/trump-recep-tayyip-edogan-middle-east-259604