A Global Stock Market rout, turmoil in the Emerging market currencies, and a probable full-blown debt crisis, all prompted by a single tweet? While President Trump might have been pleased and would want to take the credit, the reality is not as flattering as President Trump would have hoped for, given that the economy was primed for a fall. This is evident by a freefall of Turkish Lira, which was already down by more than 20% this year. To Trump’s credit, it added fuel to the fire.

The Turkish Crisis: Story so Far

The Turkish problem, that has been brewing for years, finally became a full-blown crisis last week after President Trump tweeted about doubling the tariffs on Aluminum and Steel from Turkey as USA seeks the release of Andrew Brunson, held by Ankara on terror-related charges.

While the tweet acted as a trigger, Turkish economy was doomed to collapse given the unholy trinity of soaring inflation, piling foreign debt, and Current Account Deficit had started weighing on the markets. Although the crisis was due to years of economic mismanagement, the build-up started few months back when President Erdogan after winning the re-election indicated his desire to control interest rates, thereby inducting his son-in-law as the finance minister. Pressure was exerted on the central bank against raising the interest rate despite soaring inflation and depreciating currency, as President was of the opinion that higher interest rates are “the mother and father of all evil”. This further led to investors losing confidence and sinking Lira

Deja-Vu

Seasoned market participants have seen this movie play out before, wherein a stable economy doing reasonably well borrows heavily in foreign debt during good times, finds itself in crisis, the currency plunges, investors start fleeing, question arises over country’s ability to service its debt payments, talks quickly turn to contagion, and, finally end with a costly global bailout.

Be it the Latin American Debt Crisis in early 1980s, the Asian Crisis of 1997 or the Taper Tantrum of 2013, story has remained more or less the same, wherein a sudden capital flight made the economy vulnerable. However, in case of Turkey, the plotline is slightly different. While most others involved government borrowing, in case of Turkey, borrowing is mainly by the corporates, thereby making bailout even more complicated.

Debt Disaster

The prolonged period of low interest rates in the United States following the global financial crisis had made cheap dollar- denominated loans absolutely irresistible. With surplus liquidity, foreign investors started parking money in Turkish assets, lured by superior returns in a what appeared to be a relatively stable economy. However, with USA raising interest rates, the relative attractiveness started fading, thereby leading to investors fleeing the market and currency depreciating.

The combination of a strong greenback and heavy international borrowing by Turkish Banks and non-financial businesses was a recipe for disaster as it now faces a double whammy – by expensive dollar repayments on one hand and higher debt service payments on the other.

With more than 45% of debt of all Turkish firms due by 2020, reversing the slump in Lira seems to be the only plausible option to restore financial stability and instill confidence.

Learning the Turkish Way

While turmoil in Turkey appears to go from bad to worse, the crisis offers key lessons to other countries:

• First being, One should not live way beyond its means. Turkey did so by adopting an unsustainable, highly accommodative fiscal and monetary policy to accelerate growth. The accommodative policy resulted in huge Current Account Deficits as well as significant corporate borrowings.
• Secondly, there are no free lunches. Borrowing in foreign currency for a slightly lower interest rate might look lucrative in good times, but when good times turn bad, things will quickly turn against you, resulting in a currency crisis, higher borrowing costs, and withdrawal of the “hot money”. There’s no sentiment involved in business.

One silver lining from the crisis is whether others can learn from Turkey’s mistake and get their house in order. However, sadly the history reveals that each country thinks they’re different and what happened to Turkey will not happen to them.