The Turkish economy was perilously stranded on the edge of an out and out currency-and-debt crisis on August 7 but as the markets sought an escape route President Recep Tayyip Erdogan and his new finance minister, son-in-law Berat Albayrak, appeared to be ‘missing in action’.

Traders, further unsettled by the deafening silence from the Ankara palace, looked to a lively discussion among analysts for clues as to what comes next. With Goldman Sachs warning on August 7 that Turkish banks’ capital buffers could be wiped out if the Turkish lira (TRY) reached as low as 7.1 to the dollar, and midday trade in London sending the yield on Turkey’s 10-year local currency debt past 20% for the first time, to reach 20.09% (three months ago it stood at 13.9%), Dani Rodrik, professor of international political economy at Harvard University, said on Twitter: “Turkey is going through its first currency crisis of the floating era. All the previous ones were when the rate was fixed or managed, and hence unfolded much more quickly. This one is stretched over time and the government prefers to ignore it.”

The collapsed TRY, which has fallen as far as 28% against the dollar in the year to date, has buckled under one of the world’s widest current account deficits, surging double-digit inflation and political rows with Washington, as well as a lack of tightening from the central bank under seeming government pressure. The currency was managing to hover short of the all-time low of 5.4187 to the dollar set towards midnight in Turkey on August 6—by 01:40 Istanbul time on August 8 it was trading at 5.2613—but there was still tentative talk of possible capital controls or an International Monetary Fund (IMF) bailout.

Capital Economics, however, explored the possibility of another emergency rate hike. Confidence that this may occur is brittle given that Erdogan—described as “an obsessive, volatile CEO” in charge of an economy that “has been waiting to blow up for some months” by Adam Posen, president of the Peterson Institute for International Economics, on August 2—appears to have taken charge of monetary policy and has set his face against seemingly logical interest rate hikes that go against his unorthodox ‘Erdoganomics’.

William Jackson, chief emerging markets economist at Capital Economics, in a note to investors acknowledged the deep uncertainty over who is now in control of rate-setting in Turkey, but said an emergency hike would nevertheless seem to be ahead given that the lira has now fallen by 8% against the dollar over the past two weeks and by 13% over the past month.

He said: “There is a lot of uncertainty about how things will develop. President Erdogan, a critic of high interest rates, now has greater say over economic policymaking. But history suggests that, when the fall in the lira is large enough, fears about the impact on inflation and financial stability will result in the central bank hiking interest rates (or the government allowing them to do so).”

Jackson added: “We seem to be close to that point. In the two most recent episodes in which the central bank was forced to hold an unscheduled MPC meeting to raise interest rates—in January 2014 and in May of this year—the lira had fallen by between 9% and 16% against the dollar over the previous month.”

Brunson factor
A big factor in the lira’s decline in the past week has been the row between Washington and Ankara over the fate of US pastor Andrew Brunson who remains under house arrest in Turkey as his trial centred on terrorism and espionage charges continues. The dispute has led to tit-for-tat sanctions aimed at assets of two senior government officials of each country. Jackson also noted: “Unless there are concessions from the government to improve relations with the US, it’s hard to see the central bank holding on until its next scheduled meeting on 13th September [to make an interest rate decision].”

Reflecting on how Turkey might extricate itself from the building crisis, in which the dumping of the lira is heavily exposing banks and corporates to foreign-currency debt obligations, Christopher Granville, managing director for EMEA and global political research at TS Lombard, told Bloomberg Television that one way would be “central bank independence and a much tighter monetary policy but the other quick fix, obviously, is to try to get out of this political spat with the US”.

The solution, he added, had to be “some kind of dramatic change” which “could simply be a very hard landing for the economy with high inflation and recession, total stagflation”. Turkish assets and the currency “look cheap and could get cheaper before the bounceback happens but there is going to be a shock of one type of another, either a policy shock, or a macro shock or some combination of the two, but the way to sugar that pill… would be a political accommodation with the US—that would make the pain much less in both senses and the risk of more pain correspondingly lower”.

In terms of solving the political side of Turkey’s crisis, pro-government Turkish media reported on August 7 that Washington and Ankara had reached a “preliminary understanding on certain matters” concerning the sanctions. CNN Turk said that Turkish Foreign Minister Mevlut Cavusoglu spoke to US Secretary of State Mike Pompeo ahead of a trip by Turkish officials to Washington in coming days.

Likelihood of capital controls
The introduction of capital controls to address Turkey’s crisis is seen as a drastic measure that most analysts think improbable given that unlike Russia—a large commodity economy—Turkey is a trading-manufacturing economy that needs to keep the confidence of investors to borrow and trade.

Timothy Ash, senior emerging markets sovereign strategist at BlueBay Asset Management, said: “Capital controls are now frequently mentioned, but I agree—I see these as very unlikely. More likely they go to the IMF first—and remember 2009/10 when they totally played the IMF, talking up chances of a programme, but really never being that serious. But it did turn market sentiment.”

He added that he was unsure there are many people left in the Turkish economy team under new minister Albayrak with experience of the games played nine years’ ago. Another consideration, said Ash, was that the US would want resolution on Brunson, state-controlled Halkbank’s role in an alleged money laundering scheme that evaded Iran sanctions, Ankara’s plan to acquire the S-400 advanced missile defence system from Russia “et al before greenlighting any IMF lending for Turkey”.

Another difficulty for Turkey is that unlike Russia it does not boast a sizeable fiscal or foreign exchange cushion. Its net foreign exchange reserves stand at only $74bn, meaning the central bank can do little to help businesses refinance forex debt.

“Crucially, Turkey is as dependent on investment flows as Russia is on oil,” Tatiana Orlova, founder and chief economist at Emerginomics Global investor, wrote in an August 7 piece for the Financial Times.

Orlova added that she thought “the new US sanctions have increased the odds of a balance-of-payments crisis in Turkey. I worry about the heavily indebted corporate sector. Turkish banks have about $55bn in forex deposits but they face heavy external debt repayments in the next 12 months. Both Turkish banks and companies need to retain access to external markets”.

Around two-thirds of Turkey’s trade, finance, and FDI comes from the West, but Erdogan has expressed the hope that Turkey will attract more loans from China, and other emerging market countries, much as Russia has done. “But the Russian experience shows that some foreign direct investment may be substituted, but that takes time. Turkey needs to repair its relationship with the west quickly to avoid a larger crisis,” Orlova concluded.