As the U.S. and Turkey squabble over issues such as American pastors, F-35 deliveries, and the finer points of the Syrian civil war, the Turkish lira has gone from steady decline to precipitous fall. It has declined roughly 40 percent since the beginning of the year and roughly 14 percent since the beginning of the day. Many have blamed this financial calamity on the Trump administration. After all, it has placed sanctions on a few Turkish officials, it has threatened to remove Turkey from a program that allows it to export some products to the U.S. duty-free, and just today, it announced it would double steel and aluminum tariffs.
The U.S. is often a strawman for the poor performances of struggling economies. And to be sure, the measures Washington has imposed are not good for the Turkish economy. But Turkey’s economic problems are structural, and the lira has been declining since the beginning of the year. Washington’s moves against Turkey are punitive, but they aren’t the causes of Turkey’s economic problems. They are a consequence of them – namely, Turkey’s dependence on external debt, and therefore its dependence on foreign reserves. The U.S. sees in Turkey a weakness it can exploit.
Indeed, Turkey’s economic growth since 2002 has been fueled largely by external debt – that is, debt denominated in a foreign currency. Turkey’s low saving rate means that, despite high interest rates, there was not enough local capital in the Turkish financial system to provide enough loans to spur growth. So it borrowed from foreign countries. The problem with debt denominated in a foreign currency is that it becomes much harder to pay down when the currency in question weakens. Such is Turkey’s dilemma.
To hedge against the risk from external debt, Turkey built up its foreign reserves. But it did so in a novel way. The Turkish central bank’s reserve option mechanism permits Turkish banks to hold capital reserves in not just Turkish lira, but also foreign currencies (and gold). However, if banks substitute foreign currencies for the lira as their reserves, they must deposit that foreign currency at the central bank. This means that a substantial portion of the foreign reserves held at the central bank isn’t simply something the bank can buy or sell as it chooses. It also comprises a portion of the capital reserves of the Turkish banking system.
As the lira declined this year, the central bank reduced the reserve option mechanism’s foreign exchange ratio, meaning that it allows less foreign currency to be held as reserves at the central bank in substitution for lira reserves. In May, this figure was reduced from 55 percent to 45 percent, and earlier this week, it was reduced to 40 percent. This can basically be thought of as selling foreign reserves to boost the lira. Earlier this week, it seemed to work as the lira briefly gained strength. But since many of these headline foreign reserves are basically borrowed by the central bank from individual Turkish banks, the decline in this ratio also represents a general weakening of the Turkish banking system.
As the week went on, the lira continued to fall, proving that the reserve option mechanism is ineffective and thus removing one tool the government thought it had to maintain foreign reserves. (Turkey’s foreign reserves have fallen from $95 billion to $78 billion since the beginning of 2017.) To stem the decline of the lira, Ankara may have to make the politically unpopular decision to raise interest rates. President Recep Tayyip Erdogan has discouraged further increases for fear that it will reduce the availability of credit Turkey needs to grow.
Of course, none of these developments are purely economic. A poor economy affects Turkey’s military capabilities and its politics. A weak currency means that, as more money must be dedicated toward foreign debt service, less money will go toward more productive areas of the economy. Declining economic activity will impact tax revenue, which will in turn put pressure on Turkey’s military spending – hence Turkey’s growing urgency to develop a domestic defense industry that depends less on imports. If the economy becomes unduly weak, and if Erdogan is not able to convince the country that its economic woes are solely America’s fault, then Turks may begin to question why the government is spending so much in Syria.
The president’s efforts in that regard will only aggravate tensions between the U.S. and Turkey – a curious strategy, considering the general frailty of the Turkish economy. The alliance between these sometimes-partners seems more tenuous every day.
Editor’s note: The graphic in an earlier version of this analysis contained an incorrect lira-to-dollar conversion rate. We regret the mistake, which has been corrected on site.