Turkey Faces An Economic Dilemma That Will Have Global Implications

By: John_Mauldin

BY GEORGE FRIEDMAN AND XANDER SNYDER : A country’s decision to borrow money is not always strictly economic. Take Turkey, whose ratio of gross external debt (all public and private sector debt) to GDP has jumped from 39% in 2012 to 52% today.

Turkish President Recep Tayyip Erdogan has been pushing to increase available credit to spur economic activity. This is a political goal, though one motivated by economic objectives.

But Erdogan found that there was not enough domestic capital available to meet Turkey’s lending needs.

Borrow Domestically or from Abroad?

When a country chooses to borrow, it has two sets of choices.

First, should it borrow domestically or from abroad? Second, should its debt be denominated in domestic or foreign currency? Each option has its own implications, but it is particularly constraining when a country borrows from abroad in a foreign currency.

When debt is borrowed in another country’s currency, the borrowing country no longer has the option to depreciate its own currency through monetary policy in order to decrease the relative value of its debt.

The other risk involved in foreign currency borrowing is that the borrower’s currency will decline in value and increase the cost of debt service.

For example, if a country borrowed $100 million at 10% in US dollar-denominated debt, it would owe $10 million per year.

If the exchange rate between the borrower’s currency and the dollar is 2 to 1, then that $10 million is equal to $20 million of its own currency per year.

But if its currency depreciated and the exchange rate to the dollar became 4 to 1, it would still owe $10 million, but in terms of its own currency, that figure would be $40 million in debt service per year.

Turkey’s Dilemma

The pitfalls of borrowing in foreign currency are clear. But for Turkey, domestic borrowing is not a sufficient option.

Banks lend money that is entrusted to them in the form of deposits. The quantity of deposits is determined by a society’s proclivity to save. If deposits are lacking, then the bank will have only so much domestic capital to lend.

Herein lies Turkey’s dilemma: The government wants to boost economic growth by extending greater credit to encourage investment, but there isn’t enough domestic capital in the banks to meet these goals.

Turkey’s solution to this capital shortfall has been external borrowing, though with some restrictions.

Households are not allowed to take out consumer debt that is denominated in foreign currency. Instead, it is mostly financial institutions that borrow in foreign currency—mainly US dollars and euros. And once the capital flows into Turkey, banks extend credit domestically in Turkish lira.

With this maneuver, Turkey accepts greater long-term financial risk for short-term economic growth. More credit is available for projects now. But with every borrowed dollar or euro, Turkey faces a greater financial burden should the lira’s value fall relative to the dollar or euro.

Erdogan, who overcame a coup attempt just last year, cannot afford the risk to his presidency that a flailing economy would create. Maintaining positive economic momentum is critical to ensuring the continued support of his base.

Global Implications

The need to maintain a strong lira while keeping credit freely available has opened somewhat of a rift between Erdogan and Turkey’s central bank.

The bank sees the abundance of credit and growing inflation as a threat to the lira’s strength—and thus Turkey’s ability to service its foreign debt. So it wants to increase interest rates.

But higher rates mean less credit, and Erdogan needs to keep the debt tap open to prevent an erosion of his control over the country.

Turkey’s problems aren’t just its own. Turkey has the 17th-largest economy in the world. If it were to falter, the implications for its lenders would be severe. But its finances also affect regional security (I wrote about the balance of power in the Middle East and Turkey’s role in the region in my free exclusive e-book, The World Explained in Maps, which you can download here).

If Turkey is financially stable and politically united, it can turn its gaze outward and try to exert greater control over its near abroad.

But if Turkey’s financial system is compromised in a run on foreign exchange reserves, then its economy will be threatened. In turn, Turkey could lose its ability to maintain its ever-growing military deployment in Syria.

Without a Turkish presence in western Syria, Iran, which has been Turkey’s rival since the days of the Ottoman Empire, would have a freer hand to influence areas farther west in Syria—areas that Turkey would prefer it to stay out of.

Turkey’s approach entails greater, but not unmanageable, risk. Should it fail, such as in the event of a rapid fall in the value of the lira, Turkey’s financial system—and thus its immediate ability to project power—would be weakened.

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