Turkey’s increasingly fractious relations with some key Western allies are taking a growing financial toll amid investor concerns, analysts warn.

Although the lira surged Monday on news that Turkey and the United States had resolved a dispute over the detention of some of Washington’s local employees in Turkey, the currency plummeted Tuesday following apparently contradictory statements by both sides.

The currency gyrations linked to diplomatic tensions are increasingly becoming the norm. In the space of a couple of months, Turkey’s lira fell sharply on news that a reporter working for a U.S. newspaper was convicted in absentia on terrorism charges. Additionally, the currency dropped in value amid reports that Berlin planned to sanction Ankara in the case of 11 Germans detained following a coup attempt in Turkey last year and a resulting crackdown. The tensions have led to the lira approaching record lows.

Foreign investors, attracted by relatively high Turkish interest rates offering rare lucrative returns, had until now been largely indifferent to Ankara’s diplomatic and political woes. With growing concerns, however, that Turkey’s central bank is not doing enough to contain surging inflation running at a nine-year high, political risk is entering into investors’ equations.

“From the investors’ perspective, the real [interest] rates are not only inadequate to contain domestic demand pressures, but they are also inadequate to compensate for the elevated political risk premium,” warns economist Inan Demir of Nomura Bank.

Demir says international investors’ concerns over diplomatic tensions are heightened by the fear they could now have direct financial implications for Turkey.

“It’s more customary to talk about the EU tensions and talk about it in the same breath a German veto on large financing deals for Turkey from multilateral institutions,” Demir said. 

The ongoing crackdown following last year’s attempted coup resulted in the detention of several German nationals along with a number of U.S. citizens, including a pastor, Andrew Brunson.

U.S. Vice President Mike Pence, in a statement after meeting Thursday in Washington with Turkish Prime Minister Binali Yildirim, expressed “deep concern over the arrests of American citizens, our Mission Turkey local staff, journalists, and members of civil society under the state of emergency.”

Reliance on foreign credit

The Turkish economy depends heavily on overseas borrowing. Over the next 12 months, Turkey needs to renew $170 billion in loans. The current account deficit, the difference between what it imports and exports, has surged this year to more than $40 billion, an increase from 3 percent to 5 percent of gross domestic product, or GDP. Analysts warn this will likely put further pressure on the lira.

That pressure is predicted to leave the country financially vulnerable when it comes to political uncertainties.

“The possibility of political shocks, leaving the currency alone, is almost nil,” warned political consulate Atilla Yesilada of the New York-based Global Source Partners.

“Given Turkey’s reliance on foreign credit, prolonged political pressure on global banks to reduce exposure or more bad news about potential sanctions on Ankara could have a chilling effect,” Yesilada said.

Alleged sanctions violations

The trial in New York of a Turkish Iranian businessman, Reza Zarrab, and a senior Turkish State Halkbank executive, Mehmet Atilla, accused of Iranian sanctions violations also is looming large over Turkey.

“If the guilt or the wrongdoing of the Turkish public bank, whose vice president is in jail, is proven in court, it will have severe repercussions on Turkey’s financial system,” warned international relations expert Soli Ozel of Istanbul’s Kadir Has University.

“There were some unconfirmed reports about a big bill of penalties prepared for several Turkish banks and that would obviously shake Turkey’s financial sector and Turkey’s economy seriously, which relies on cheap credit in order to run its affairs. The repercussion for the Turkish economy and, therefore, Turkey’s political stability and the grip of the president on the country can be very serious,” Ozel added.

In the next two years, Turkey is due to hold presidential and general elections. With President Recep Tayyip Erdogan predicted to face a closely fought election, he is widely seen as increasingly using anti-Western rhetoric to secure nationalist voters. Analysts warn any financial turmoil triggered by international sanctions or fines on Turkish banks is likely to see Erdogan further ratcheting up his nationalist rhetoric, which could further unnerve foreign investors.

“There is that risk the political tensions will escalate and in a manner to affect the external financing outlook for Turkey, and the resulting market pressure would lead Turkey to adopt an even more uncompromising stance, and that intensifies pressures on the market even further,” said economist Demir.

Demir warns such a vicious cycle poses the danger of a fundamental change in foreign investors’ lending attitudes toward Turkey and with it considerable risks to its currency. “The scenario where Turkey is facing an external funding shock because of political tensions could easily deliver a depreciation well in excess of the level of 20 to 25 percent levels.”
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