Turkish tremors will cause shocks in Britain
There are many strange things about Recep Tayyip Erdogan, but one of the oddest is his pet theory about interest rates.
The Turkish president believes that high borrowing costs produce high inflation. “The interest rate is the cause and inflation is the result,” he said a few months ago. “The lower the interest rate is, the lower inflation will be.”
No, you didn’t misread that. In defiance of economic orthodoxy (not to mention centuries of experience) which says that high interest rates tend to reduce inflation, President Erdogan believes the opposite. As one economist put it, this is a little like believing that umbrellas cause rain.
The Turkish president’s eccentric attitude towards monetary policy is not the only reason his country is now facing an economic crisis, but it is at least part of the explanation.
Over the past decade or so, Turkey became one of the great bubbles of the modern era. Housing bubble? Check. Debt binge? Check. Yawning current account deficit? Check. Runaway inflation? Check. These traits alone qualified the Turkish economy for crisis candidacy some time ago. But as always, saying a country is due a crunch is far simpler than predicting when and how. And Turkey may well have muddled through a little longer were it not for four critical ingredients.
The first was rising US interest rates. We know from experience that when the world’s largest economy tightens policy, we should expect a monetary butterfly effect across the world. Hitherto stable economies are toppled, recessions are provoked, nowhere more so than in countries which borrowed lots of dollars. Which emerging economies have the world’s biggest amounts of dollar debt? Step forward Argentina, Chile and Turkey. Argentina has already had its own crisis and is being bailed out by the International Monetary Fund. Turkey may be next.
The second ingredient was what happened after July 2016. In the wake of an attempted coup, Erdogan doubled down. He clamped down on free speech, jailed more of his opponents, including an American pastor he claimed was fomenting unrest, rewrote the constitution giving himself more powerand, in an effort to muster support, poured yet more stimulus into an already red-hot economy. Sure enough, the bubble got even bigger; international investors started to clear off and one of those arrests came back to haunt him.
Which brings us to the third ingredient: Donald Trump. With half an eye on his Christian voters, the US president recently demanded that Erdogan release the jailed pastor. Last week, he slapped sanctions and tariffs on Turkish exports. The lira, already the worst-performing currency in the world, collapsed. For an economy as reliant as Turkey on dollar funding, this is a disaster. At this stage the only sane response, save for calling in the IMF, is to impose austerity and hike interest rates, 17.75 per cent at present, well into the mid-twenties. But (fourth and final ingredient), that runs smack into Erdogan’s pet theory.
No one can quite work out whether Erdogan’s antipathy towards interest rates is down to religion (they are technically banned under Sharia), conspiracy theories about usury and Zionist bankers, or is simply a reflection of the fact that his crazier advisers now have the upper hand. Either way, it is a strange departure for a man once regarded as an exemplar of prudence. In his early days in office, Erdogan and his AK Party slayed inflation. This time around, the best the president can do is to urge his people to boycott American brands, such as Apple. Quite something, coming from the man who, during the 2016 coup, resorted to broadcasting an emergency address to the nation using FaceTime on his iPhone.
There are some obvious questions: first, are Turkey’s problems enough to provoke a repeat of the 2008 crisis? Short answer: probably not. But saying the world’s financial system will avoid collapse is not the same as saying it may not face a serious setback. Turkey is only one extreme example of a trend across emerging economies, many of which rode the wave of zero US interest rates and a Chinese boom and now face a sudden stop. Ukraine, South Africa, Mexico and Brazil all look vulnerable and that’s before one mentions the biggest bubble of all, the one we have all been fretting about for years: China.
Who is most exposed to this looming crisis? Conventional wisdom says Spain and Italy, whose banks have Turkish subsidiaries. However, this slightly misses the point, since much of that lending is in lira. Those banks should be able to survive even the loss of their stakes. The real question is: who has been lending Turkish companies all this foreign exchange debt? That brings us to the sting in the tail. For when you dig through Turkish treasury data, as the Deutsche Bank economist Oliver Harvey has, you discover that the country that lent most to Turkey, both short and long term, was the UK. That’s right: Britain, or more specifically the City of London, is by far the most exposed to a collapse in the Turkish economy.
And so we return to a running theme in this column. Since the City is a giant machine creating and directing money and financial instruments and distributing them around the world, it is unusually exposed. The good news is that the Bank of England is well aware of this, and has gamed out some potential consequences. However, the lesson of 2008 is that even when you assume the worst, the reality could be even more terrifying.