Turkish turmoil to send economic storm clouds over US soon

In imposing punitive tariffs on Turkish aluminum and steel exports, the Trump administration has broken with decades of U.S. emerging market crisis management.

Instead of trying to help defuse Turkey’s dramatic currency crisis, as was done for instance in the 1998 Asian currency crisis, the Trump administration seems to have gone out of its way to exacerbate that country’s crisis.

{mosads}The Trump administration has done so despite the likelihood that this will bring forward the date by which Turkey will default on its debt and impose exchange controls.

That in turn is all too likely to result in real contagion to the rest of the emerging market economies, which could come back to adversely impact the U.S. economic recovery.

Anyone doubting that Turkey is now at serious risk of defaulting on its external debt has not being paying attention to the International Monetary Fund’s (IMF) most recent staff report on that country. In that report, the IMF draws attention to two basic vulnerabilities that must raise questions about Turkey’s external debt sustainability.

The first vulnerability to which the IMF draws attention is the large amount of Turkey’s debt that is U.S. dollar-denominated and that is subject to valuation risk.

To underline this point, the IMF notes that if the Turkish lira were to experience a 30-percent depreciation from its level at the start of the year, Turkey’s external debt would rise to over 80 percent of GDP.

This has to be of real concern since to date, the Turkish lira has depreciated by well over 40 percent. If sustained that depreciation would take Turkey’s external debt to around 100 percent of GDP.

The second vulnerability is that Turkey has an unusually high external financing need. Not only is Turkey running a large current account deficit of around 5 percent of GDP. It also has short term external debt of more than 20 percent of GDP that it needs to roll over.

As a result, Turkey needs to tap the global financial market for around $250 billion a year if it is to stay afloat and not default on its external debt obligations.

Turkey’s $250 billion financing need makes it all too likely that the Turkish lira will remain weak. That in turn would make it prohibitively costly for Turkish companies to continue servicing their very large external debt mountains.

Contrary to the wishful thinking in which President Erdogan is engaging, Russia and China are unlikely to be disposed to anywhere nearly fill such a large financing gap.

Rather, the only real hope for Turkey to stabilize its currency without resorting to exchange controls or to default on its debt would be for the country to restore investor confidence by seeking an IMF-backed economic stabilization program.

Sadly, there are two serious obstacles impeding Turkey approaching the IMF anytime soon. The first is Erdogan’s strong belief that the higher interest rates that the IMF is almost certain to demand as a condition for an IMF loan would be a cause of inflation rather than a cure of Turkey’s economic imbalances.

The second is that Erdogan would have to bury his hatchet with the United States, which remains the IMF’s largest shareholder. Without U.S. support, Turkey has no chance of securing an IMF bailout program.

On the eve of the 10th anniversary of the Lehman Brothers crisis, one must hope that U.S. policymakers gain the insight to appreciate the real risks that a highly indebted country like Turkey could pose to the U.S. and global economies.

After all, Turkey’s economy is around four times the size of Greece’s. In much the same as in 2008, a crisis at a small U.S. investment bank managed to destabilize the rest of the global economy, one would think that a Turkish debt default has the real potential to derail the U.S. economic recovery.

Hopefully, an appreciation of the risks posed by the emerging market economies to the U.S. economy will make U.S. policymakers take those economies into greater account in setting U.S. economic policy.

However, judging by President Trump’s attachment to an “American First” trade policy and the Federal Reserve’s seeming haste to normalize U.S. monetary policy, I am bracing myself for the U.S. economy to be hit by a major emerging market economic storm well before the November midterm elections. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.