U.S.-Turkey crisis exposes Erdogan’s Achilles heel

(Updates with Erdoğan meeting with Tillerson in the eighth paragraph.)

A crisis in relations between Turkey and the United States is exposing the Achilles heel of President Recep Tayyip Erdoğan – his country’s massive current account deficit.

Short-term portfolio inflows, which Turkey relies on to finance the deficit, turned into outflows in the final two months of 2017, the latest balance of payments data show, meaning the central bank was forced to use its own foreign currency reserves to plug the gap.

Political tensions between Ankara and Washington have reached unchartered territory because of a spat over U.S. support for Kurdish militants in Syria, which led to a Turkish invasion of its neighbor last month, and a court case in the United States that exposed an alleged scheme by Turkish bankers and senior government officials to circumvent U.S. sanctions on Iran.

The drying up of capital inflows “shows the toll that foreign policy tensions are taking on the balance of payments,” said Inan Demir, an emerging markets economist at Nomura in London. “Given that the central bank reserves are not strong, it won’t be possible for the central bank to fund the external deficit if we see a renewed and protracted period of international tensions.”

Data published by the central bank on Wednesday showed that the current account deficit jumped 42 percent to $47.1 billion in 2017, equivalent to 5.6 percent of economic output, the highest among major emerging markets. The gap for December alone was $7.7 billion, the biggest number for a single month since December 2013.

At the same time, $341 million of portfolio investments flowed out of Turkey in November and December combined. The exodus compared with $5.2 billion of inflows in the previous two months, central bank figures showed.

The halt in funds from abroad, coupled with an increase in imports, meant that the central bank was forced to use its foreign currency reserves to fund the current account deficit, to the tune of $4.1 billion in November and $8.6 billion in December.

With the crisis with the United States showing little sign of abating, Secretary of State Rex Tillerson arrived in Turkey’s capital late on Thursday for talks with top level government officials. He met with Erdoğan for more than three hours at the presidential palace in Ankara, with only Turkish Foreign Minister Mevlut Çavuşoğlu in attendance and acting as a translator. There were no statements to the press afterwards.

Earlier in the week, Erdoğan threatened the United States with an “Ottoman slap” unless it vacated the Syrian enclave of Manbij, where U.S. special forces are training and arming Kurdish militants in the fight against Islamic State (ISIS).

U.S. Secretary of State Rex Tillerson (Source: Anadolu Ajansi)

Erdoğan has repeatedly threatened an armed confrontation with the United States because of its support for the Kurds. The People’s Protection Units (YPG), trained and supported by Washington as part of the Syrian Democratic Forces (SDF), is affiliated with the Kurdistan Workers’ Party (PKK), Turkey-based militants recognised as terrorist by the U.S. and European Union. Turkey has fought a three-decade war against the autonomy-seeking PKK at the cost of about 40,000 lives, most of them Kurdish, and says the YPG is indistinguishable from the group.

The crisis with the United States and the resultant impact on capital flows comes at a time when Erdoğan, eyeing early elections, is pushing ahead with measures to boost the economy, spurring demand for imports and widening the current account deficit still further.

The deficit "underlines the problems and risks for the Turkish economy,” said Tim Ash, senior emerging markets strategist at BlueBay Asset Management in London. “Higher oil prices are obviously not helping. But in the end one cannot escape the obvious conclusion that the economy is being run at warp speed to get to (early) elections and all Star Trek fans know that that can risk burn out if sustained too long.”

Turkey current account deficit

Unless Erdoğan steps back from the crisis with the United States, he may unwittingly instigate a run on the lira or cause a significant slowdown in domestic demand, spoiling economic plans that he has so carefully crafted.

Demir said that, given Erdoğan’s reluctance to slow the economy, increasing political tensions with the United States could mean that the burden of an adjustment required in the current account would fall on the lira first and then on domestic demand.

Turkey’s central bank has net foreign currency reserves of just $32.9 billion. Gross reserves, which also include banks’ foreign currency reserve requirements, are $116 billion. These are not enough to cover 6 months of imports – a key measure used by economists to measure the strength of a country’s foreign exchange position. They also fall far short of some $170 billion of external debt maturing in the next 12 months.

The political crisis with the United States already sparked a slump in the lira during October and November. The currency fell to a record low of 3.96 to the dollar in late November. Most of the losses were caused by the U.S. suspending visa services for Turkish citizens on Oct. 8, a response to the detention by Turkish police of one of its consular employees on terrorism charges.

Further U.S. sanctions could be on the cards unless the crisis is resolved. The participation of a Treasury official specializing in sanctions at a meeting of the Senate Foreign relations Committee on Turkey last week, an unusual move, suggests a new-found U.S. interest in possible financial and economic measures.

Turkey is out of control and sanctions targeting its banks, corrupt officials or the defence industry should be on the table as a means to rein in Erdoğan, Eric Edelman, U.S. ambassador to Turkey between 2003 and 2005, and Jake Sullivan, a former foreign policy adviser to Hillary Clinton, recommended in an op-ed for Politico this week. Turkey has agreed with Russia to buy S-400 missiles from a Russian firm already on a U.S. sanctions list, meaning Turkey could face penalties too should it go through with the deal.

Dangers to Turkey’s economic health may also come from the rising price of oil. Brent crude is at $63.3 a barrel compared with around $45 in June. Turkey imports nearly all of its oil and gas meaning an increase in the cost of the commodities is automatically reflected in the current account. Several of its natural gas import contracts are also based on the price of crude.

On Feb. 1, Goldman Sachs raised its predictions for the oil price in three months and six months time to $75 and $82.50 respectively, citing growth in global demand and OPEC supply cuts. Saudi Energy Minister Khalid al-Falih said on Wednesday that OPEC and its allies planned to maintain production cuts even as global demand continued to grow. The coalition would "stick with the policy throughout 2018", he said.

In an interview with Reuters this week, Deputy Prime Minister Mehmet Şimşek, Erdoğan’s most senior minister for the economy, said the government will prioritise keeping the current account deficit under control as it seeks to spur economic growth during 2018.

That pledge may be unachievable unless the crisis with the United States is resolved and foreign funds flow into Turkey's bond and stock markets in greater numbers. Otherwise, the government has few tools left to avert a painful adjustment in the economy.