Mustafa Sönmez

For years, Turkey encouraged sectors that lavishly borrowed and spent foreign exchange rather than investments that would generate much-needed hard currency. The party is now over. Ruled by the Islamist Justice and Development Party (AKP) since 2002, the country has amassed a giant external debt of $466 billion. Although the writing was on the wall for months, the Turkish economy hit the rocks last week.

Plagued by a chronic current account deficit and unrelenting inflation and unemployment rates, the Turkish economy’s burden has recently grown with gaping public deficits, resulting in “non-investment” grades by international credit rating agencies. On top of all this came severe tensions with the United States that resulted in unprecedented sanctions on Ankara, culminating in a Black Friday for the Turkish economy Aug. 10.

The economic hemorrhage is continuing and the real sector is on the edge. Many now wonder which businesses are first in line to throw in the towel. Are companies close to the AKP among them and could they receive a lifesaver from the government? The turmoil is so encompassing that few companies are likely to escape unscathed. Still, the cronies could be in a greater danger. Before discussing why, a brief overview of how Black Friday transpired is worthwhile.

No doubt, the row between Ankara and Washington bore on the turbulence that led to Black Friday, but Turkey’s economic indicators this year were already alarming. Inflationjumped to almost 16% in July, and the year-on-year current account deficit never eased below $57 billion, reaching 7% of gross domestic product. Despite government incentives to sustain economic growth, the seasonally adjusted unemployment rate kept growing. Fiscal discipline was undone, leading to significant public deficits. Turkey’s risk premium, reflected in credit default swaps, was already at about 320 basis points, sharply decoupling from other emerging economies. Hence, the tensions with Washington only aggravated this gloomy outlook.

In June, when Turkey held presidential and parliamentary elections, the dollar traded for 4.63 Turkish liras on average. The lira was expected to strengthen with the removal of political uncertainty after the polls, but this did not happen. Lack of confidence in President Recep Tayyip Erdogan’s regime hit the currency further, with the dollar’s average price reaching 4.75 liras in July.

On Aug. 1, Washington slapped sanctions on two Turkish ministers over Ankara’s refusal to release American pastor Andrew Brunson, which plunged the lira into a freefall anew, with the price of the greenback hitting 4.9 liras that day. The meltdown continued in the ensuing days as the new inflation data offered no hope of improvement and the prospect of reconciliation with Washington weakened, pushing the price of the dollar to more than 5.5 liras.

On Aug. 10, Turks woke up to financial havoc as the lira had already nosedived on Asian markets. The currency’s fluctuations saw drops of as much as 15% during the day as the dollar’s price shot up above 6 liras.

Ankara’s attitude was far from helpful. A defiant Erdogan declared, “If they have their dollars, we have our God,” while his son-in-law, Finance Minister Berat Albayrak, made a rather shallow economic presentation to business leaders. To make things worse, US President Donald Trump announced on Twitter he was doubling tariffs on Turkish steel because ties with Turkey were “not good at this time.”

The lira, which had sunk to 6.87 against the dollar at one point, closed Black Friday at 6.43 against the greenback. The increase in the dollar’s price stood at 70% since the beginning of the year, 37% over a month, 27% over a week and 12% for the day. Turkey’s risk premium, meanwhile, shot up to a staggering 437 basis points, up from 333 basis points on Aug. 1. As Erdogan spoke of an “economic war” against Turkey, the lira’s meltdown continued when financial markets reopened Aug. 13, forcing the central bank to step in with measures to provide liquidity.

It is hard to gauge whether the lira has hit the bottom or if there is more to it, but the country’s descent into a full-blown crisis appears inevitable. The huge increase in foreign exchange prices is bound to further fuel inflation, which, in turn, will be eroding real incomes. Companies are clearly unable to cope with such exchange rates, which will force many to scale down their operations and lay off workers. This will mean a decline in GDP, a sharp contraction and a crisis.

Companies with foreign exchange deficits are first in line to take the hardest blows from the turmoil. According to central bank data, the net foreign exchange deficit of nonfinancial companies stood at $217 billion in May. The deficit, which was $74 billion in 2010, has widened largely due to borrowing, a trend that has intensified notably since 2013 amid privatization tenders and large infrastructure projects conducted as public-private partnerships (PPP).

Some of the indebted businesses operate in the manufacturing industry, but central bank surveys indicate that most of the companies that are indebted and run deficits are those involved in PPP projects in the fields of infrastructure, energy and transport.

According to World Bank data, Limak Holding tops the PPP investment list with $43 billion, followed by Cengiz Holding and Kolin with approximately $40 billion each and MNG with $18 billion. Together with Kalyon, those four companies are building Istanbul’s third airport, one of Erdogan’s pet projects. They have all benefited from foreign loans.

The IC Group, which built the third suspension bridge over the Bosporus, is also high on the list with $16 billion in investments. In the energy sector, Sabanci Holding, whose rapport with the AKP has become increasingly open in recent days, has invested $5 billion in PPPs.

Having used significant foreign loans to carry out those projects, crony companies are now at the sharp end of the currency crisis. Many of them were also the winners of major privatization tenders in the power distribution sector several years ago. The sell-offs were denominated in dollars and the companies borrowed from abroad to pay for the acquisitions.

Building companies involved in the construction boom, which saw luxury high-rises, shopping malls and health complexes mushrooming across the country, especially in Istanbul, are believed to have notable foreign exchange gaps as well, as is Turkish Airlines, the national flag carrier, which has used foreign loans to expand its fleet.

The banks that intermediated for those companies, including Turkish banks affiliated with Europe-based lenders, are also on tenterhooks now, facing the specter of serious damage.

Since the June 24 elections, Turkey’s rulers have been trying to squeeze the nation into the clothes of a one-man regime. This outfit was sewn by the Justice and Development Party (AKP) over its 16 years in power, partly in tandem with Fethullah Gulen’s religious community, which the AKP now labels a terrorist group. Given Turkey’s advanced level of integration with the globalized economic order, this new political garment has spawned a big question about the fate of the already ailing Turkish economy. Can the financial system carry on within the confines of this attire? Will domestic and foreign economic actors be able to adapt and acquiesce to it?

Made of conservative, Sunni Islamic cloth, the new outfit is tailored for a governance style that subordinates the legislative and the judicial branches almost exclusively to a single person — the president. The arrangement — officially called the presidential government system and narrowly approved in a controversial referendum in April 2017 — took effect after the June 24 elections, in which President Recep Tayyip Erdogan won re-election.

Compared with other emerging markets such as Brazil, India, Mexico and South Africa, Turkey stands out as the one with the highest level of power concentration in single hands, with constitutional rights and freedoms severely suppressed and the media and universities largely transformed into government instruments. Hence, Turkey faces a peculiar risk of alienation and decoupling in its relationship with global capitalism.

The new governance system has eliminated checks and balances and made the country vulnerable to the failings of a single person by largely disabling the parliament’s legislative and supervision functions, empowering the president to shape the judiciary and placing the executive under his exclusive control.

On the executive front, the new system empowers the president to appoint Cabinet ministers and vice presidents, while remaining at the helm of his party. In one of his most notable moves, Erdogan merged the Treasury and the Finance Ministry, handing the post to his son-in-law Berat Albayrak. Major economic and financial institutions, including the central bank and public banks, were all attached to Albayrak’s ministry. In short, Erdogan established full control over the economy.

When it comes to the judiciary, 12 of the 15 Constitutional Court judges are appointed by the president, with the remaining three left to parliament. All members of the Court of Appeals, three-fourths of the Council of State members and four members of the 13-member Judges and Prosecutors Board are directly selected by the president, in addition to the justice minister and the minister’s undersecretary who sit on the board.

The president also appoints the members of the Higher Education Board, which controls universities.

Parliament has lost most of its legislative influence over a president who has the power to govern by decree. Parliament can counter his decrees only if the opposition holds the majority in the legislature, which is not the case at present. Although the AKP lost its absolute majority in the June 24 polls, it continues to dominate parliament thanks to its alliance with the Nationalist Action Party.

The president is empowered to shape the country’s national security policies and can declare states of emergency. The parliament’s budget-making mandate has also been transferred to the president. A judicial probe against the president can begin only if 301 lawmakers in the 600-member parliament vote for such a move, while subjecting the president to a trial at the Supreme Court would require 400 votes. The president can also easily call elections.

Given Erdogan’s record of polarizing policies and nepotism over the years, foreign financial actors in particular doubt that he will use his new powers to make the right decisions for the economy. Just weeks before the elections, Erdogan dismayed institutional investors during a trip to London, contesting central bank independence and conventional economic theories.

Now that the country has acquired its new political clothing, the confidence of foreign investors is slipping further. Turkey’s risk premium hit a record high of 345 basis points Aug. 2 after Washington slapped sanctions on Ankara over the detention of an American pastor, marking an unprecedented low in the tense ties between the two NATO allies. A higher risk premium means higher borrowing costs for Turkey at a time when the provision of fresh external funds is crucial for its economy.

Key economic indicators have only worsened since the one-man regime began to function. Inflation has continued to climb, the Turkish lira has slumped further — with hard currency becoming even more expensive — and market expectations have hardly improved. Investors continue to shun the lira, whose freefall broke the psychological mark of 5 against the dollar Aug. 1. Normally, the central bank is supposed to hike interest rates to prop up the currency, but it has failed to act. As a result, the Turkish economy remains squeezed between rising hard-currency prices and already high lending costs of about 25%.

Under the impact of this pincer, year-on-year consumer inflation hit almost 16% in July, while producer inflation reached 25%, with no prospect of easing in the near future.

The tensions with the United States appear bound to add new layers to the economic fragilities, as the AKP refuses to abandon its confrontational tone vis-a-vis Washington. According to some observers, Ankara might even use the crisis as an opportunity to shift the blame of the economic downturn to foreign powers, especially the United States, perpetuating its long-standing narrative of external enemies seeking to undermine Turkey’s progress.

While announcing his 100-day program Aug. 3, Erdogan made another appeal to citizens to “take out” the hard currency and gold they keep “under the pillow,” convert their savings into Turkish liras and funnel them into the financial system. Yet given the ongoing increase in foreign exchange prices, his call appears to have had little effect, even on his own supporters. On another note, Erdogan said Turkey would not leave itself dependent on the West and turn to the Chinese market for borrowing, though he offered no explanation why the Chinese would treat Turkey differently than American and European lenders.

Given Turkey’s advanced integration with the global economy and its heavy dependence on it, Ankara’s task of managing the country’s financial system is becoming increasingly difficult under the one-man regime. Turkey’s foreign trade amounts to half of its gross domestic product, and foreign assets in Turkey range between $650 billion and $700 billion. Unlike Iran and Russia, Turkey is not an energy exporter, which makes its new political outfit even more awkward to dance in on the Western-dominated economic scene.

Some observers suggest the AKP’s essential priority is to keep wearing the outfit rather than engage in the economic dance with the West. The AKP, the argument goes, has no other option but to preserve and impose the new clothing and cares little about what shape the economy will take in it, whether it is a collapse or contraction, and will rely on its political might to gag and suppress those who speak up to complain.

While the economic outlook appears to be pushing Turkey toward the International Monetary Fund (IMF), a critical question is looming for the AKP regime. If it chooses to seek IMF aid, the bailout would certainly come with strings attached. So would Turkey acquiesce to demands for transparency, accountability, stamping out cronyism and respect for human and property rights or would it choose to keep its new political attire untouched at the expense of whatever fate befalls the economy and force the nation to acquiesce to it? Will Turkish voters, including AKP supporters, tolerate an economic option involving high unemployment and poverty, and if they do, for how long?

The embattled Turkish lira hit a new low late Aug. 1, breaking the psychological mark of 5 against the dollar as Washington slapped unprecedented sanctions on Ankara in a simmering row over a detained American pastor. The mounting bilateral tensions and their economic impact come atop alarming signs of how President Recep Tayyip Erdogan will handle the ailing economy under the one-man rule he has been building since his victory in the June elections. Though few in Ankara would admit it, the prospect of Turkey running for aid from the International Monetary Fund (IMF) is looming large.

The new Cabinet that Erdogan formed after the elections had to grapple with growing economic woes immediately after it took office. Among the Cabinet members, the president entrusted the biggest authority to his son-in-law, Berat Albayrak, by appointing him treasury and finance minister and attaching the central bank to his ministry. Though Erdogan had ostensibly delegated powers, he seemed to cast a long shadow on both Albayrak and the central bank when the latter convened July 24 to make a decision on interest rates and send the first major signal on how Erdogan’s new administration would run the economy.

The markets anticipated a hike of at least 100 basis points to prop up the Turkish lira and curb the menacing rise of hard-currency prices. Albayrak reinforced the anticipation, pledging ahead of the meeting to not fight with the markets and instead pursue “a win-win relationship” with them. But the meeting ended with a shocking decision to keep the policy rate unchanged, which markets perceived as a direct order by Erdogan, given his well-known aversion to high interest rates and unconventional economic views that have long perturbed investors.

The lira, which was gaining ground toward 4.6 against the dollar ahead of the meeting, nosedived anew. The greenback’s price ultimately broke the 5 lira psychological mark Aug. 1 as the United States imposed sanctions on two ministers over Ankara’s refusal to release pastor Andrew Brunson, who Washington said is “the victim of unfair and unjust detention by the government of Turkey.”

The Turkish economy has been stuck between mounting hard-currency prices and already high lending costs of nearly 25%. While both trends have a bruising effect on the economy, Erdogan seems bent on maintaining his opposition to hiking rates at the expense of further increases in hard-currency prices, which contribute to fanning inflation.

Hopes of reining in inflation have dimmed, with the rate standing at more than 15% in consumer prices and more than 24% in producer prices. The upward trend is likely to continue and reach 20% in consumer prices and at least 25% in producer prices at the year-end. The increased cost of imports — the result of the rise in hard-currency prices — is a major factor pushing up the inflation.

In its July 31 inflation report, the central bank revised its year-end inflation projection to 13.4%, an increase of 5 percentage points from 8.4% in April. The report said that the rate is expected to fall to 9% in 2019.

Many local and foreign observers doubt the credibility of those projections. While the inflation trend offers no prospect of easing, there is a growing conviction among observers that the one-man regime lacks the ability to take things under control.

Because of high inflation, other economic indicators have been deteriorating as well. While the climate of uncertainty is discouraging investments, inflation is eroding real incomes and curbing domestic consumption. As a result, the shrinking demand is bearing on economic growth, which has relied largely on the domestic market. The Turkish economy, which grew 7.4% in 2017, is expected to slow in the third quarter before beginning to contract.

The growing uncertainties are discouraging also the inflow of hot money from abroad, which Turkey desperately needs. Moreover, existing foreign investors have been fleeing the Turkish stock market, albeit slowly — a trend that contributes to sustaining the high prices of foreign exchange, especially the dollar. Accordingly, Turkey’s risk premium — reflected in credit default swaps (CDS) — is on the rise. Turkey’s CDS, which had stood at 166 basis points Feb. 1 and 199 basis points May 1, hit a record high of 334 basis points on the evening of Aug. 1 — up from 321 points in the morning.

The increasing risk premium means that Turkey will now face higher interest rates when it tries to borrow from foreign creditors. The country’s external financing needs for the next 12 months amount to $230 billion, including $180 billion to roll over external debts and $50 billion to cover its gaping current account deficit. Hence, the question of how the required funds will be secured and at what cost is crucial. The tensions with Washington came amid this already serious crunch, exacerbating the woes of Erdogan’s regime.

The row over Brunson had flared last week, as both President Donald Trump and Vice President Mike Pence threatened sanctions unless Ankara took “immediate action” to release the pastor, who is being held on what Washington sees as bogus charges of espionage and collaboration with terrorist groups.

The warnings had an immediate economic effect, pushing up Turkey’s risk premium, as pundits sought to predict the scope of the upcoming sanctions. Some suggested that Washington’s hardening stance would bear on the flow of foreign capital to Turkey and the support it might seek from the IMF, while others saw trouble looming over Halkbank, the Turkish public lender embroiled in a scheme to evade US sanctions against Iran. Ultimately, Washington announced sanctions on Interior Minister Suleyman Soylu and Justice Minister Abdulhamit Gul under the 2016 Magnitsky Act, which targets individuals and entities involved in human rights abuses. According to Bloomberg, this “could be just the start of what would look like a US assault on Turkey’s vulnerable economy,” including a potentially hefty fine on Halkbank.

The political quarrel between the two NATO allies is clearly harming the Turkish economy, with the sanctions having an immediate effect on the currency. Yet Ankara’s failure to hike interest rates on the lira to counter the rise of foreign exchange is leaving Turkish companies in limbo. Both indebted companies and the banking sector, which is struggling with bad loans, are under severe strain.

The banking system is already under the scrutiny of international credit rating agencies. In a July 30 report, Fitch Ratings warned that the multiple risks to Turkish banks that led to widespread rating downgrades in July continue to threaten their credit profiles. “Depreciation of the Turkish lira, higher interest rates and slowing economic growth pose significant risks to banks’ performance, asset quality, capitalization, funding and liquidity,” it said. “We expect sector performance to deteriorate in 2018, and most of the banks’ ratings are still on Negative Outlook or Rating Watch Negative.” Earlier in July, Fitch downgraded its already “junk” rating on Turkey’s sovereign debt as well as the ratings of 24 Turkish banks.

The gloomy outlook painted by credit rating agencies makes the provision of external funds all the more difficult, pushing Ankara step by step to the IMF’s door.

The Justice and Development Party has long boasted of ending the era of IMF debts and austerity programs for Turkey, and Erdogan has even claimed that the IMF has sought to borrow from Turkey. At the current stage, however, the country’s economic conditions are increasingly dictating the IMF option — though the government will go to any lengths to avoid conceding to it.

Turkey’s June 24 presidential and parliamentary elections, held 16 months ahead of schedule, produced no remarkable change in the country’s political topography. On the economic front, the climate of uncertainty that the elections had created is over, but economic visibility has not improved and the risks have not eased. For both domestic and foreign actors, the Turkish market remains fraught with unknowns, prone to surprises and far from inspiring confidence, as evidenced by vital indicators such as hard currency prices, interest rates and the risk premium for foreign investors.

The price of the dollar, which measures the pulse of the Turkish economy, was about 4 Turkish liras in mid-April, when President Recep Tayyip Erdogan called the early elections. Under the impact of both domestic and external negative factors, the dollar climbed to 4.9 against the lira in May, forcing the Central Bank to hike interest rates despite Erdogan’s longstanding pressure for lower rates.

In two months’ time, rate hikes totaling 5 percentage points brought interest rates to nearly 18%, but savings holders continued to shy away from the lira amid an unrelenting inflation that hit 12% in consumer prices and more than 20% in producer prices in May. More importantly, lack of confidence in the government has persisted among domestic and foreign actors alike, sustaining hard currency as a safe form of keeping savings.

The trend has changed little since the June 24 polls. The dollar’s price closed the first week after the elections at about 4.6 liras, reaching 4.7 liras occasionally during the week. This price is no different from the pre-election levels, suggesting that the polls and their outcome have contributed little to improving confidence among economic actors.

The same result can be observed on the risk premium front. Turkey’s risk premium, reflected in credit default swaps, had risen above 320 basis points ahead of the elections, exceeding that of Greece, and remains above 300 basis points after the polls. The risk premiums of other emerging economies such as Brazil and Russia stand respectively at about 270 and 140 basis points. The risk premium is important in determining the interest rate that Turkey pays for external borrowings. In other words, when borrowing from abroad, Turkey has to shoulder the rate shaped by its risk premium, atop the rate of 10-year US bonds.

The amount of foreign funds that Turkey needs to secure over the next 12 months is $233 billion — now with the added burden of higher interest rates. This total includes the rollover of $183 billion in external debt and $50 billion to finance the country’s annual current account deficit.

Erdogan and his Justice and Development Party (AKP) may have a renewed mandate of five years, but this does not mean the funds will be easily available. Besides the problem of confidence among foreign actors, the global financial climate is no longer in favor of emerging countries such as Turkey. The US Federal Reserve’s ongoing normalization of monetary policies and rate hikes, coupled with tightening monetary policies in the European Union, have already curbed the flow of hot money to emerging economies and even led to occasional flights. US President Donald Trump’s trade wars and the oil tensions with Iran are also negatively affecting countries such as Turkey. Given Turkey’s dependence on foreign energy supplies and its massive oil and gas imports, each increase in energy prices adds to the country’s current account deficit and further fuels inflation.

Moreover, political uncertainties in Turkey are far from over, despite Erdogan’s victory in the presidential polls that entitled him to far-reaching executive powers. Erdogan’s party finished first in the parliamentary vote, but fell short of an absolute majority in the legislature. The AKP is now dependent on the support of its ally, the Nationalist Action Party (MHP), which is hardly a promise of political stability. The possibility of the MHP using its critical position to obtain political benefits or even for political blackmail is a major factor sustaining the confidence problem.

The reports of international credit rating agencies have become even more important for foreign financiers after the elections. Moody’s has already voiced its misgivings. “Even if the current account deficit narrows in the second half of the year due to the impact of the weaker lira and a slowdown in domestic demand, the deficit will remain large in absolute ($50 billion) and relative (6% of Gross Domestic Product) terms,” the agency said in a June 26 statement.

“Notwithstanding the growth of the economy in recent years, Turkish authorities have made only limited headway in addressing the structural economic problems that ultimately give rise to its persistent external deficits. Increasingly expansionary fiscal policy has stimulated growth to unsustainable levels, whereas longer-term economic reforms intended to raise potential growth on a sustainable basis have been largely sidelined,” it added.

Referring to the sweeping presidential powers under the new governance system, the agency said, “Executive presidency model confers broad powers — both political and economic — on the president. The macroeconomic policies that Mr. Erdogan’s government adopts will ultimately determine whether Turkey will be able to reverse its rising external vulnerability, which has been exacerbated by expansionary fiscal and monetary policy in the last two years.”

In other words, Ankara is expected to quickly tighten fiscal and monetary policies. This would mean a complete reversal of pre-election steps that served to enlarge the budget gap such as tax facilities on fuel or bonuses for pensioners.

Turkey’s biggest business group, the Turkish Industrialists and Business Association, has voiced similar expectations. In a June 28 television interview, chair Erol Bilecik called for fiscal discipline and an economic program that “would reduce inflation to single digits and then to below 5%.”

An increasing number of observers believe Ankara will end up running for help from the International Monetary Fund (IMF) unless it shifts to belt-tightening policies. According to former Central Bank Governor Durmus Yilmaz, now a lawmaker for the opposition Good (Iyi) Party, “Turkey today is a few steps away from the IMF’s door. Urgent measures are required. Comprehensive reform is a must.”

What experts mean by “reforms” is essentially measures to narrow the gap in public finances, which comes atop a chronic current account deficit. It would effectively amount to an IMF program without the IMF, but the prospect of such austerity steps remains unclear.

Will the AKP’s strategic ally, the MHP, stand behind a belt-tightening program that will embitter the electorate? Municipal elections scheduled for March 2019 are seen as a major factor deterring Ankara from braving the bitter pills. Moreover, the construction and housing sector, a key driver of economic growth under the AKP, is already in a highly fragile state. Austerity measures would push the sector further into a crisis — a prospect that makes belt-tightening moves all the more difficult for Ankara.