Turkey and sanctions: the calm before the storm? - Capital Economics
Emerging Europe Economics

Turkey and sanctions: the calm before the storm?

Emerging Europe Economics Update
Written by Jason Tuvey
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Turkey’s financial markets have taken the US sanctions imposed yesterday in their stride, but the threat of harsher measures in the context of the country’s weak external position could result in a fresh sell-off in the coming days. This would act as a headwind to Turkey’s economy, raise the risk of severe strains emerging in the banking sector and temper the central bank’s appetite for further aggressive rate cuts.

  • Turkey’s financial markets have taken the US sanctions imposed yesterday in their stride, but the threat of harsher measures in the context of the country’s weak external position could result in a fresh sell-off in the coming days. This would act as a headwind to Turkey’s economy, raise the risk of severe strains emerging in the banking sector and temper the central bank’s appetite for further aggressive rate cuts.
  • Late yesterday, US President Donald Trump announced that he had signed an executive order to impose sanctions on Turkey in relation to the country’s recent incursion in Syria. The order imposes assets freezes on Turkey’s interior, defence and energy ministers, as well as the country’s energy and defence ministries. Meanwhile, the US has raised tariffs on Turkish steel imports from 25% to 50%. And negotiations over a US-Turkey trade deal have been suspended.
  • Investors breathed a sigh of relief that harsher measures were avoided – there had been rumours that Turkish banks might be targeted – and local financial markets have rallied. The lira strengthened by as much as 1% against the dollar earlier today, although it has pared since pared some of those gains. And the stock market is up by 1.5%, partially reversing a 5% plunge yesterday.
  • At this stage, we think that there are three points worth making. First, more aggressive sanctions remain a strong possibility. US officials have urged Turkey to agree to an immediate ceasefire or the sanctions regime will be tightened over the coming days and weeks.
  • There appears to be strong bipartisan support in the US for more aggressive action. The muted market response so far flies in the face of President Trump’s threat to “obliterate Turkey’s economy” and so may force the US government to consider harsher measures. A belligerent response from President Erdogan may also prompt the Trump administration to double down.
  • US troops are set to be pulled out of north-eastern Syria over the coming days, but there is still the risk of military missteps that trigger a severe deterioration in relations between the US and Turkey. If harsher measures are forthcoming, today’s rally in Turkish financial markets is likely to prove short-lived.
  • Second, although the direct macroeconomic impact of sanctions is likely to be limited, the bigger risk is the indirect impact on financing conditions. Turkey has (along with Argentina) the weakest external position in the emerging world, which leaves the economy vulnerable to a bout of investor risk aversion. The central bank is not in a position to mount a credible defence of the lira. And any support for the currency from state banks is likely to be limited and temporary.
  • If Turkish financial markets do come under fresh downward pressure, the resulting tightening of financial conditions will stifle the recovery from last year’s recession. The impact would probably be a lot more severe if sanctions are expanded to include Turkey’s financial sector. As we noted yesterday, a rise in wholesale borrowing costs could result in strains in the banking sector. (See here.)
  • Meanwhile, the central bank would probably be more hesitant to press ahead with further interest rate cuts. In fact, past experience shows that a 5% fall in the lira against the dollar within the space of a month has tended to be the trigger for rate hikes. (See here.)
  • Third, the imposition of sanctions has reignited talk of Turkey turning to capital controls in a bid to support the lira, although we doubt that these would be effective. There have been signs over the past year that the authorities are edging towards a more restrictive capital regime. But it’s not clear that officials have the necessary experience or infrastructure in place to prevent leakages.
  • Even if controls are limited to restricting resident’s ability to take money out of the country, the threat of the net being widened is likely to deter foreign investors. And without steps to tackle the country’s problem of high inflation, capital controls would simply store up a larger falls in the lira further down the line. (See our Emerging Markets Economics Update.)

Jason Tuvey, Senior Emerging Markets Economist, +44 20 7808 4065, jason.tuvey@capitaleconomics.com