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Market players have been paying a lot of attention to Turkey recently, thanks to the Turkish lira’s very steep slide against the U.S. dollar on August 10.

USD/TRY: Daily Chart
USD/TRY: Daily Chart

But what brought about this crisis? Will the lira continue to slide? Does the lira’s slide have an effect on other economies? Well, this primer will hopefully help you get to grips with the lira situation.

How did it start?

The Turkish lira has actually been steadily depreciating against the U.S. dollar since late 2013.

USD/TRY: Daily Chart
USD/TRY: Daily Chart

Market analysts cite various reasons, but they generally boil down to two reasons, which happen to be interlinked.

And these two reasons are:

  1. Turkey’s super high inflation
  2. The Turkish central banks failure to control inflation

Those two reasons have been scaring off foreign investors, thereby weakening demand for the lira even further. Yeah, it’s a vicious cycle.

And if you’re wondering, Turkey’s inflation problems are due to (among others) climbing oil prices, the weaker lira, a stronger U.S. dollar, and more recently, Turkey’s high GDP growth fueled by cheap credit and infrastructure projects.

Turkey’s annual inflation rate currently stands at +15.85%

That last bit, in particular, is also another cause of concern for investors since market analysts have been pointing out that many major Turkish corporations have been borrowing in U.S. dollars and those infrastructure projects were financed to a large degree by speculative flows.

It’s therefore another vicious cycle since a weaker lira means that it would be harder for Turkish companies to meet their foreign debt obligations, thereby increasing the odds that there will be defaults, which will spook investors even further, thereby dampening demand for the lira all the more.

Heck, some market analysts are even already saying that Turkey is on course for an economic meltdown.

As for the Central Bank of the Republic of Turkey’s (CBRT) failure to control inflation, well, CBRT Governor Murat Cetinkaya said recently that CBRT members “make decisions based solely on the inflation outlook,” stressing that Turkish law “clearly grants the central bank independence in its objectives and tools.”

In other words, Cetinkaya is saying that the CBRT is independent and doesn’t take orders from Turkish President Recep Tayyip Erdogan.

However, investors doubt that… and for good reason.

I don’t really want to dip my toes into politics, but I’ve got no choice it seems. Anyhow, Erdogan is on record as saying the following way back on October 20, 2016:

“I am an enemy of interest earnings. I see it as a tool of exploitation.”

And before that, he was saying the following on March 1, 2015.

“There is a very serious threat from the interest-rate lobby … anyone who defends this [higher rates] is at the beck and call of the interest-rate lobby, this is treason against this nation.”

And that’s not really new since Erdogan has been railing against high interest rates and a perceived interest rate lobby before he even became president.

But why did the Lira slump hard recently?

Okay, we’ve established that the Turkish lira has been sliding for years. But why did the lira slump super hard almost three weeks ago (August 10)?

Well, investors got another reason to avoid investing in Turkey and/or pulling out their investments from Turkey, namely this:

The stated pretext for Trump’s decision to tighten the screws on Turkey is Turkey’s ongoing imprisonment of Andrew Brunson, who is a U.S. Christian pastor arrested back in 2016 on terrorism charges (later amended to spying) for allegedly aiding Fethullah Gulen, one of the individuals being accused of masterminding the 2016 coup attempt against Erdogan.

However, I suspect that Trump also upped the ante against Turkey because Turkey played hard ball. To be more specific, Turkey was on the list of victims of Trump’s tariffs on aluminum and steel, which was announced way back on March 1 of this year.

Instead of playing nice and asking to renegotiate a trade deal that’s more “balanced” (from Trump’s perspective), Turkey decided to escalate the situation by imposing counter-tariffs against the U.S.

So why all the fuss about Turkey?

Well, it all started when the Financial Times released an August 10 report claiming that ECB officials were supposedly getting worried about the exposure of E.U. banks and other lenders to the Turkish lira’s steep depreciation at the time.

This fueled fears of a potential contagion effect into the Euro Zone, which caused the euro and the major equity indices to plunge hard as a result, with European banks taking the biggest hits.

Overlay of EUR Pairs: 1-Hour Forex Chart
Overlay of EUR Pairs: 1-Hour Forex Chart

It should be pointed out that the ECB hasn’t given an official statement on the Turkey situation, though.

Is the threat of contagion real?

The lira has been finding support lately, thanks in part to the CBRT’s announcement that it will cut reserve requirements and provide liquidity for Turkish banks, which helped to ease fears a bit.

However, Turkey has been staunchly refusing to give in to Trump’s demand that Brunson be released, so it’s probable that Trump will continue to tighten the screws on Turkey down the road, which will likely translate to more weakness for the lira.

But even if Turkey finally gives up and appeases Trump by releasing Brunson, and even if Trump responds by lifting sanctions against Turkey, Turkey’s inherrent economic problems will still remain, which skews probability more towards further weakness on the lira’s part.

Does that therefore mean that a potential contagion scenario is inevitable?

Not really, market analysts say.

According to an article from The Globalist, “The impact on Eurozone GDP growth would be small. Even if Eurozone goods exports to Turkey were to fall by, say, 20%, this would subtract no more than 0.1 percentage points from growth in the big Eurozone.”

And to provide more context to Turkey’s economy, Turkey’s annual GDP “now amounts to about €750 billion. That is equivalent to 6.5% of Eurozone GDP,” according to the report.

Economists cited in a Reuters report also shared the same views since “Analysts see as manageable even a worst case scenario – which they deem unlikely at present – under which these banks would be forced to write off completely their local operations or exit the country.”

The Reuters report also noted that the following five European banks were the most vulnerable to further declines in the lira.

  1. Spain’s BBVA
  2. Italy’s UniCredit
  3. France’s BNP Paribas
  4. The Netherlands’ING
  5. Britain’s HSBC

However, the Reuters report’s general message is that while a worst-case scenario would indeed be very painful, it would still be survivable.

Having said that, it should be noted that the market is an emotional animal, so if the Turkish lira resumes its slide, there’s a risk that market players may respond with a bit of risk aversion that may snowball into something bigger.

For now, however, the market appears to be listening to reason and the Turkey situation is moving to the background again.