The standoff between President Trump and Turkish President Recep Tayyip Erdogan is intensifying. Investors have reason to worry about a potential financial collapse in Turkey, but we should also worry about how wide it could spread.
During a rally in the Black Sea port of Ordu last week, Erdogan “[called] out to those in the United States. It is a shame. You are trading a strategic NATO ally for a pastor. You cannot tame our people with threats.” He was referring to the US sanctions against Turkey for its imprisonment of an American priest.
The Turkish lira in free fall
Erdogan’s refusal to meet the US demands sent Turkey into a full-scale financial meltdown that is sending tremors through global markets. Its swiftness underlines how brittle the Turkish economy is after years with a growth-at-all-costs policy bias that has resulted in hundreds of billions of dollars in foreign debt. In just one day, the lira dropped a stunning 17 percent for a total yearly loss of 42 percent. In addition to its imploding currency, Turkey faces massive economic problems and devastating deficits.
This development threatens to spread into Europe and across emerging markets. Many EU banks have lent money to Turkey, so they may be facing another crisis themselves. The banks include Spain’s BBVA (which has lent $18 billion to Turkey) and France’s BNP ($40 billion).
Corporate defaults and bank failures
According to Win Thin, a strategist at Brown Brothers Harriman & Co. in New York, “This is a textbook currency crisis that’s morphing into a debt and liquidity crisis due to policy mistakes. The way things are going, markets need to be prepared for a hard landing in the economy, corporate defaults on foreign currency debt, and possible bank failures.”
While Turkey’s currency is collapsing, the gold price in lira is skyrocketing, up by four times since 2013. Turkey is mirroring the hyperinflation we are seeing in Venezuela and Argentina, and it’s only going to get worse. Turkish banks hold a lot of loans to Turkish borrows in foreign currencies such as the US dollar—those loans make up 40% of their balance sheets. Most of those banks will likely see their reserves wiped out because their clients won’t be able to repay their loans in lira.
This is important to Americans because Turkey could be the first one to drop in the global economy—just like Iceland’s 2007 economic collapse foreshadowed the Great Recession of 2008.