Turkey’s economic meltdown threatens stability of Europe

It is time to think about Turkey — the country.

It may be a faraway place you know little about, but it borders the European Union, has a population more than twice the size of Canada and is about to default on a material portion of its $446 billion (U.S.) of external debt. This means financial loss for some investors but it can also bring greater political turmoil to Europe and further declines in the value of the euro.

Today, one U.S. dollar buys almost 15 Turkish lira. When 2021 began, it bought less than eight Turkish lira. Official data shows consumer price inflation rising at more than 20 per cent year on year.Some well-informed authorities believe it could now be running at above 80 per cent per annum.

In the past, such situations have spiralled into a period of hyperinflation. Turkey is no stranger to such outcomes. As recently as 2005, the country dropped six zeros from its bank notes, transforming, for instance, the 10 million lira note into a 10 lira note. It is not possible to service your foreign currency debt when the value of your exchange rate collapses so quickly. Major debt defaults by companies and possibly the Turkish government now seem very likely.

Turkey has a gross external debt position, money loaned from non-Turkish entities, of $446 billion. To put this into context, the total on balance sheet liabilities of Lehman Brothers when it collapsed was just more than $600 billion. Nonetheless, Turkey’s debts to the rest of the world are big enough to be important. Some of this $446 billion owed to foreigners is loaned in Turkish lira by local commercial banks owned by foreign banks. However, $262 billion is in the form of bank loans and international debt securities, in foreign currency.

It is getting difficult to keep up with the true size of the Turkish economy, given the rate of inflation and collapse in the exchange rate, but it is around $700 billion. Its foreign debt to GDP ratio is at a level where default has historically been common. From 1901 to 2001, Turkey (for part of that period known as the Ottoman Empire), defaulted on its government debt obligations six times. That is a higher number of defaults over that period than either Brazil or Argentina.

If you happen to invest in an emerging market debt fund you will be exposed to losses should Turkey, either its corporations or its government, be unable to repay their debts.

Across the world, other funds, such as pension funds, have invested in Turkish debt securities, pursuing the higher yields on such instruments. Those who hold local currency fixed interest securities are already nursing large losses due to the collapse of the Turkish exchange rate. Fortunately, most of these securities are well distributed throughout the world financial system and the owners, such as pension funds and mutual funds, have not themselves borrowed money to fund their investments.

While some European banks will be nursing large losses from their investment in Turkey, it is unlikely that defaults on Turkish debt securities, whether denominated in Turkish lira or foreign currency, will create a systemic risk for the global financial system. Those defaults on its debts are just part of a broader economic collapse that will threaten stability in the region.

Turkey, a country with slightly more people than Germany, has been home to the world’s largest refugee population since 2014. According to the United Nations, it has 3.6 million refugees from Syria and a further 330,000 refugees from other jurisdictions, particularly Afghanistan. The EU struck a deal with Turkey in 2016 to prevent these refugees from journeying into Europe by funding The EU Facility for Refugees in Turkey. So far it has committed six billion euros to support these refugees.

For a Turkish administration watching its exchange rate and economy collapse, there is leverage in the fate of these nearly four million displaced people.

In desperation could the administration allow these refugees to attempt the crossing into the EU in an attempt to secure more financial support from the EU? If they did and they succeeded, in so crossing would this destabilize the already fractious relationships between EU member states on the issue of immigration?

In fact, Turkey’s continued economic meltdown could have profound political ramifications for the EU, if it instigates the mass migration west.

Turkey’s importance to the stability of Europe cannot be overestimated.

The country has an army of 355,000 — bigger than any single member of the EU and more than eight times larger than Canada’s. Turkey is a member of NATO but has long-standing territorial disputes with Greece, another NATO member. Greece recently signed a defence pact that would commit France to intervene to defend Greece should it be attacked by a third party. France, in return, will be selling Greece ships and warplanes to defend it from its only natural aggressor, Turkey.

Meanwhile, the U.S., which has nuclear weapons in Turkey, is vociferously opposed to Turkey’s recent purchase of the S-400 air defence missile from Russia.

Things are complicated for this portion of the NATO alliance and an economic collapse in Turkey significantly increases the risks of a local administration acting desperately in desperate times.

And it’s not just within NATO that the military situation has become more precarious. Turkey has military aspirations in the region and has provided military intervention, whether through troops on the ground or the provision of war material, in Syria, Ukraine, Iraq, Libya, Azerbaijan and Qatar.

In Ukraine, Turkish supplied drones played a key role in attacks on Russian forces. In 2015, Turkey downed a Russian warplane on the Syrian/Turkish border. The Turkish navy has recently been active in expelling vessels from waters near Cyprus. This is part of a claim to the oil reserves in those waters. Turkey’s claim is not recognized by the United States, the European Union or key Eastern Mediterranean states.

There are any number of flashpoints between Turkey and its NATO allies and with Russia. History is littered with examples of political regimes that have sought to distract attention from local economic difficulties with various forms of what are sometimes euphemistically called “foreign adventures.”

There is much focus today on territorial disputes involving Taiwan and Ukraine as they involve two powerful military forces in Russia and China. Meanwhile, there is little focus on the economic collapse of Turkey and what it might mean for mass immigration to the EU. There is even the risk of military confrontation within the EU borders.

Turkey is much more strategically important than Argentina or Venezuela or Zimbabwe, other countries that have recently lurched into hyperinflation.

The EU sells much more to the world than it imports but despite this the Euro exchange rate is declining. This decline reflects the exodus of capital.

The continued economic deterioration in Turkey and the risk of even larger political problems for the EU will probably lead to further capital outflows from the Eurozone and a further depreciation of the euro.