Why Turkey’s currency is plunging—and the global fallout

Turkey’s currency and stock market kept on falling Monday, weighed down by investor fears about the country’s economic policies and worsening relations with the United States.

The lira fell as low as ₺6.89 to the U.S. dollar Monday, down about 7% on the day and 45% since the start of the year. The main stock index fell 3.5%.

Here is a look at some of the reasons behind the plunge and how it might affect the rest of the world.

Read: What to consider as currency volatility increases

Q: Why is Turkey’s currency so weak?

A: One reason is that cheap borrowing rates in major economies like the U.S. are rising, attracting investors’ money away from emerging economies like Turkey.

Ultra-low interest rates in the U.S. and Europe had for years encouraged companies in Turkey to borrow in foreign currencies. That helped the economy, which booked 7% growth last year. But now, the U.S. Federal Reserve is raising rates.

That draws capital away from Turkey, weakening the currency. And it makes it more expensive for Turkish companies to repay foreign currency debts, raising economic concerns that can further weaken the currency.

Read: How U.S. dollar, trade talks are affecting currencies

Q: How is the fall in the lira a problem?

A: It is a problem for Turkish businesses and banks that get revenues in lira and owe money in dollars or euros. The lira has fallen about 40% against the dollar this year. That makes a loan in dollars that much more expensive to repay. So the sudden fall raises the possibility of corporate bankruptcies or bank failures that could hurt the economy.

The currency drop will also increase the cost of living for people in Turkey by making imports more expensive. Prices are already up 16% since last year, and this week’s drop will make that worse.

(About 35% of loans made by Turkey’s domestic banks are in foreign currencies, says Stéfane Marion, chief economist at National Bank, in a report.)

Q: What impact could the turmoil have outside Turkey?

A: There are some concerns about whether European banks would suffer losses on loans in Turkey. The euro currency dropped to a 13-month low on Friday, and bank shares fell.

Tom Kinmonth, senior fixed income strategist at ABN Amro Bank, has calculated that European bank exposure is limited in Turkey. Spain’s BBVA has significant exposure, with 31% of pre-tax profit coming from Turkish operations. UniCredit, BNP, ING and HSBC have smaller businesses there.

Outside those five banks, he said, European exposure is “minimal.”

Marion compares Turkey’s crisis to that of Greece a decade ago.

“It is worth noting that foreign banks’ exposure to Turkey (US$260 billion) is just as large as in Greece circa 2008,” he says in the report, implying that market effects won’t necessarily be contained to Turkey. Canadian banks have “very limited” exposure to Turkey, he adds.

Trouble in Turkey could make investors reassess their holdings in other emerging markets. So far, however, Turkey has not sparked a global rout in emerging markets.

Additionally, Europe is nervous because it depends on Turkey to restrain the flow of migrants from conflict in the Middle East in return for aid. Some four million displaced people, most from Syria, are currently living in Turkey. Any resumption of serious migrant flows from Turkey would be a big political issue in Europe, where opposition to immigration has fueled the rise of right-wing parties.

Q: What about Turkey itself?

A: Its economy has long shown signs of overheating. Inflation hit 15.9% annually in June. The country has run a large trade and investment deficit with the rest of the world, buying more than it sells and relying on foreign investment and lending. That deficit can weigh on a currency, especially when foreign investment stops flowing in.

As the currency weakens, it can make foreign investors pull their money out of Turkish stocks and bonds as their lira investments lose value. To do that, they have to sell lira—worsening the rout.

Q: Is it just economics?

A: Politics has played a role, too. The lira’s fall has been made worse by President Recep Tayyip Erdogan’s statements on economic policy. He has urged the central bank to not raise interest rates. Rate increases are the central bank’s main tool to support the currency and fight inflation, though they can slow growth. The central bank appears to have heeded Erdogan and has not raised rates when many—including the International Monetary Fund—have urged it to. That drained investor confidence in the central bank, leading to a further sell-off of the currency.

Erdogan’s decision to name his son-in-law as finance minister also made people wonder about the direction of the country’s economic policy.

Q: What about the dispute with the U.S.?

A: Turkey’s decision to jail a Protestant pastor from the U.S. has led to the U.S. imposing sanctions on two Turkish government ministers. Conservative evangelical Protestants are a key constituency for U.S. President Donald Trump.

The mere fact that the U.S. would impose sanctions on Turkey—a stalwart NATO ally for decades during the Cold War—has increased uncertainty about the future in Turkey.

Trump raised the stakes Friday when he said his administration would double its tariffs on Turkish steel and aluminum. That caused a further drop in the lira. The U.S. was Turkey’s biggest export market for steel last year, though exports have fallen since.

Q: What is Turkey proposing to do?

A: In theory, Erdogan could turn to the International Monetary Fund for financial help. He could also impose limits on money transfers to keep capital from fleeing. So far he’s shown no sign of doing either.

Having to obey IMF conditions in return for assistance would be a blow to his prestige. Money controls could backfire because Turkey needs foreign investment.

Instead, Erdogan has doubled down. He has mainly blamed foreigners for trying to destabilize the country and equated the financial turmoil to the 2016 coup attempt that sought to depose him. He told supporters to “change the euros, the dollars and the gold that you are keeping beneath your pillows into lira at our banks. This is a domestic and national struggle.”

The central bank has taken steps to make short-term credit more easily available to banks, but has not raised interest rates.

Beyond those steps, Marion says foreign help will likely be required to stabilize financial markets in an economy that’s seven times larger than that of Greece.

Read the full National Bank report.

Also read: Investment risks for the second half of 2018