Turkish economy: Strange days...

When trying to predict the economic prospects of a vibrant country like Turkey, politics is always one of the main determinants of the equation.  This is not only because Turkey is being governed by an intensively “consolidated” management style with the president of the country having a say in almost every event, but also a combination of factors, for example, the country’s heavy dependence on external financing to the tune of $210 billion for 2018 alone.

Turkey government bond 10y

In the near term, the Zarrab-Atilla trial will begin in early December. The Iranian-Turkish businessman and the deputy chief executive of state-owned Halkbank are accused of bypassing United Nations and U.S. sanctions on Iran by illegally channelling billions of dollars through the U.S. banking system. Zarrab is thought to have turned witness for the U.S. state and would be due, therefore, to unveil details of the global transactions he, Atilla and others made between 2010 and 2015 in defiance of the sanctions. According to prosecution evidence and exhibits presented in the case, Turkey’s government was fully aware of the dealings, officials including some ministers were bribed and a number of Turkish banks were openly involved in gold trading with Iran. 

The Turkish government perceives the Zarrab case as an attempt to discredit and topple President Recep Tayyip Erdoğan.  The case is portrayed in Turkey as the second phase of a failed coup attempt last year that the government says was orchestrated by a former political ally of Erdogan; Islamic cleric Fethullah Gülen, who currently resides in the United States.

With Turkey unsuccessfully demanding the cleric’s extradition, thorny relations between Ankara and Washington have been further poisoned by the U.S. government’s choice of working with Syrian Kurdish forces, despite their links to the Kurdistan Workers Party (PKK), which has been fighting Turkey since 1984.

NATO formally apologised and said it was an “unfortunate mistake” that Erdoğan and Turkey’s founder Mustafa Kemal Atatürk were depicted as “enemies” at one of its exercises last week, but Turkey withdrew 40 of its soldiers and the episode added to Ankara’s sense of encirclement.

Referring to the World War One Anglo-French agreement that divided most of the Middle East, Turkish government officials have said a new Sykes-Picot is in the making. In other words “the powers that be” are ganging up against Turkey and attacking with economic measures, rather than with tanks and guns.

Unsurprisingly, this extension of World War One just happens to coincide with Turkey’s elections in 2019, when Erdoğan will seek a strong majority to ensure the country’s passage to a full presidential system. Some commentators on the nationalist side of the political spectrum are now calling on the government to cut Turkey loose from the Western world and to join the Eurasia camp under Russia.  

But of course are such scenarios feasible or even possible? 

There is not much doubt that the world we live in today is profoundly different from that prior to the 2008 global financial crisis. An aggressive Russia would like to see Turkey aligning with itself rather than NATO, the European Union or the United States; even though Russia is certainly not a replacement for the economic anchor the West provides. The administration in Ankara now seems alienated politically and cornered economically.

Given the circumstances, it now seems increasingly less possible for Turkey to get away with its past misconduct in both economics and politics, as it will have serious repercussions for the economy.  

Turkey CDS (Source: Bloomberg HT)
Turkey CDS (Source: Bloomberg HT)

Zarrab’s illicit gold trade, revealed four years ago by a covert group of Gülenists within Turkey’s establishment will now make it into media headlines across the globe. Such news will not directly implicate Erdoğan, who was elected by a slender majority, but it is possible that the United States could levy financial penalties on a number of Turkish banks, which could total $20-30 billion. This threatens to impact the whole of the economy.

To begin with, strong economic growth, achieved at the cost of a wider budget deficit and a higher current account gap, will lose steam in 2018 due to the lira's steep losses. And the lira stands to lose further ground if the Turkish banking sector is weakened as a result of the Zarrab case. Funding from abroad, needed to finance growth and keep many mid-sized firms afloat, is already shying away from Turkey due to the state of emergency in place since the failed coup.   

While the central bank’s measures to anchor the lira with forward currency transactions appear insufficient amid such political tension, even a large rate hike to cap lira weakness could prove too little, too late.

Dollar-lira spot rate (Source: Trading Economics)
Dollar-lira spot rate (Source: Trading Economics)

Erdogan has once again directed criticism at the central bank for keeping interest rates high, which he says creates inflation. He called for an intervention and ruling party spokesman Bekir Bozdağ on Monday hinted that an attempt to lower interest rates could be implemented shortly. Erdoğan is expected to meet the heads of state banks and ministers responsible for the economy this week. A direct takeover of central bank policy is not on the cards, but various measures to pull down banks’ lending costs, relaxing liquidity requirements for further lending and/or forced cuts to deposit rates could be possible, further threatening economic stability.     

Since the government sees the Zarrab case as a “clear plot against Turkey, lacking any legal basis” and that Zarrab may soon be forced to “level accusations against Turkey,” the government is set to become more and more intransigent as the trial unfolds. Anti-Western rhetoric will only get louder as we go into the critical 2019 elections.

Yet with a huge external financing gap stemming from the private sector’s mounting external debt, the Turkish economy will crack if such political stress is prolonged for another one-and-a-half years. Therefore, early elections in the first half of 2018 appear more likely than they did a couple of months ago. That would provide a stage for the ruling AKP to create political capital by lashing out at the West. But a straight win is certainly not a done deal amid all the economic troubles, which are becoming more tangible by the hour.