Soaring Dollar-Denominated Debt
Central to Turkey’s Crisis

Art by John Cuneo

Turkey’s embattled leader, Recep Tayyip Erdogan, blames the US for his nation’s troubles. And he’s right, though not in the way he means: His nation’s reliance on American dollar-denominated foreign debt is what has sent it careening into an economic quagmire.

Following a spree of economic mismanagement, Erdogan is now embroiled in a high-stakes showdown over sanctions with the United States. President Donald Trump has slapped onerous tariffs on Turkish steel and aluminum as part of an ongoing tiff over an American pastor imprisoned in Turkey.

All of which has taken a heavy toll on the Turkish economy. The iShares MSCI Turkey exchange-traded fund is down 31% this year, while the Turkish lira has tumbled 45% versus the US dollar.

Erdogan trains his ire on Trump. In a recent speech, he accused the US president of fomenting “a political, underhanded plot” whose aim is to “make Turkey surrender in all areas, from finance to politics.”

But Turkey’s woes have little to do with any overt steps Washington has taken against it. Rather, the chief culprit is Turkish banks’ penchant for borrowing enormous dollar amounts from Western lenders. Unfortunately for them, the dollar has soared in value this year, which increases the Turks’ debt burden.

To burnish his record as he ran for reelection, Erdogan added to the mess by mounting a huge government spending program, constructing enormous public works projects such as Istanbul’s new airport. (He won handily in June.) The increasingly authoritarian Erdogan, who controls the central bank, has mandated that interest rates be kept low—a bad idea when inflation is running at more than 10%, yet politically advantageous as credit keeps flowing to Turkish citizens.

Result: External debt owed by Turkey’s private and public banks is nearing 80% of the nation’s economic output, the largest amount in the world. When the lira drops, debt servicing costs and default risk rise.

The big issue now is whether Turkey’s woes are contagious. The worst case of economic contagion was in 1997 and 1998, when heavily indebted Southeast Asian countries imploded. The standard thinking in the US investment community is that Turkey is idiosyncratic, because the Asian nations had much closer economic ties. Still, Turkey is far from alone: Argentina and South Africa also are weighed down by large foreign borrowings.

The good news: The bulk of Turkey’s external loans are in European banks, but the damage is unlikely to overwhelm them because they have sufficient capital to cover any losses. “Any contagion won’t be widespread,” said Richard Schmidt, portfolio manager for global equity and emerging markets at Harding Loevner.

That said, anyone who invests in Turkey, the world’s 17th-largest economy with just under $1 trillion in gross domestic product, has been hurt.

Investors in emerging markets generally have taken lumps from the Turkey problem—in conjunction with the slowing Chinese economy (which hurts emerging economies dependent on commodity exporting) and a brewing trade war between China and the US. The iShares MSCI Emerging Markets ETF is off 4% this year.

What Erdogan needs to do, according to critics in the West, is more drastic: take a bailout from the International Monetary Fund, which surely would require strict controls over Turkey’s economic behavior, and raise interest rates. The US, of course, has large influence over the IMF. “Going hat in hand to the IMF would be difficult for him,” said Arjun Jayaraman, portfolio manager of the Causeway Emerging Markets fund. “But he has to suck it up.”

Erdogan has rejected such ideas vehemently, and castigated those suggesting an IMF bailout and rate hikes as “the interest rate lobby.” High rates, he said, “are the mother and father of all evils.”  The country previously has taken IMF loans, and was forced to put up with the international body’s fiscal requirements. Amid the financial crisis in 2008, when he was prime minister, Erdogan rejected an IMF loan proposal that called for belt-tightening.

Intransigence is Erdogan’s hallmark. “There’s minimal indication of his shifting his stance,” noted Howie Schwab, portfolio manager for the Driehaus Emerging Markets Growth fund.  

Since a thwarted 2016 coup by a faction of the military, Erdogan has further expanded his power. He named his son-in-law the finance minister, removed high civil service officials in favor of loyalist replacements, and jailed numerous journalists.

Whether Erdogan will succeed despite the US is anyone’s guess. Yet he is full of plans. He has taken several steps to deal with immediate challenges, such as introducing measures to ease restructuring distressed corporate loans and making betting against the lira tougher.

At odds with the US, he also has turned to other powers for help. Although Turkey is a NATO member and houses US military bases, Erdogan has cozied up to Russia, another target of American sanctions. Turkey has signed contracts with Moscow to receive more natural gas and a nuclear power plant.

Meanwhile, the Mideast emirate of Qatar has pledged $15 billion in direct investments for Turkey to help it during its currency crisis. And Turkey is seeking to cultivate Beijing, whose Industrial and Commercial Bank of China reportedly made it a $3.6 billion loan in July.

Turkey has some inherent strengths, like a diverse economy with a strong manufacturing base and decent growth. GDP rose an annual 7.4% in this year’s first quarter, the most recent period reported. Research firm Statista forecasts that it will go up 7.1% for all of 2018. The Economist writes that it is the world’s eighth-biggest food producer and has 43 of the top 250 international construction firms. Turkey also is a major provider of TV sets for Europe.

None of that will help if the currency is a joke. “Turkey has gone off the cliff,” Harding Loevner’s Schmidt said. “Now the question is how far it will fall and who will pick it up.”