Turkey is among five emerging countries (Brazil, Indonesia, India, South Africa and Turkey) referred to as “the fragile quintet.” Some members of this quintet may change over time, but these five have been mainstays in the quintet so far. The primary reasons to be categorized as such are high inflation, weak growth, high external deficit and high dependence on “hot money.” These factors make the fragile quintet very susceptible to geopolitical developments.
The dependence on foreign capital reflects the underdevelopment of the country’s financial markets and, in a way, outpaces that economy’s structural problems. This foreign capital or “hot money” flows out in the short term so the host country needs to attract further “hot money” via high interest rates, creating a vicious cycle. In such countries, internal stability, which is indispensable for the sanctity of their financial markets, has not been fully achieved and structural problems in the national economy persist.
Significant consumption and investment combined with a low savings rate result in a large current account deficit. This is accompanied by a rise in non-resident portfolio inflows which increase Turkey’s reliance on volatile short-term capital inflows of “hot money.” Around 75% of the current account deficit is financed by short-term portfolio flows making Turkey highly susceptible to changes in investor sentiment. Increasing inflation, higher oil prices and lira depreciation all erode household income.
These Turkey-specific economic circumstances have made the Turkish financial system vulnerable to recent geopolitical developments, especially from the U.S.
Today, the U.S.-Turkey partnership is frequently tested across numerous issues. Firstly, there is the issue of U.S. support for the Syrian Kurdish People’s Protection Units (YPG) which Ankara considers as a terrorist group related to the PKK. Secondly, Turkey’s purchase of the Russian S-400 missile defence system defies U.S. sanctions on Moscow while emphasizing Turkey’s increasingly cozy relationship with Russian President Vladimir Putin. The U.S., in turn, decided to halt Turkish sales of its F-35’s.
Many international investors have taken note of these developments, along with mounting debt, and fled. Over the last two years, the lira has surrendered 40% of its value against the American dollar. This drop lifted the prices of imported goods like gasoline and fertilizer, fuelling inflation.
After the 2008 financial crisis, Turkish banks took advantage of the American central bank zeroing out interest rates to spur revival free money by borrowing dollars. They lent greenbacks to Turkish businesses eager for an alternative to the lira’s high borrowing costs. Such transactions were attractive because the lira was then appreciating, and the Turkish economy was rapidly expanding. But, in recent years, as the lira has fallen, companies with revenues in lira and debts in dollars have come under severe Forex pressure. Turkey’s medium- and long-term foreign currency debts exceeded $328 billion at the close of 2018 with private companies responsible for about two-thirds. Private companies added a further $138 billion in foreign exchange debt due in the following year. Given that Turkey’s overall economic production was about $766 billion last year, these numbers are disturbing.
Turkey’s future hangs in uncertainty as global geopolitical events add upheaval to a national economy already burdened with debt and inflation. But, Turkey is living with the hope that it can come through this difficult period.