Turkey's government faces politically unsavoury measures to pull the country back from the brink of economic collapse amid risks of contagion by European banks and emerging markets.
Gripped by one of the worst currency routs in emerging market history, Turkey's economic pain could spread beyond its banking system to import-reliant sectors and heighten the risk of exposure of European lenders, particularly Spanish and Italian ones, to the crisis, analysts said. Taking a cue from countries that suffered currency collapse, Turkey's options include tighter monetary policy and a rescue package from the International Monetary Fund--both unappealing to policymakers.
"International investors would like to see the same actions taken in Argentina recently: much higher interest rates, [and] a commitment to address inflation, improve fiscal performance and engage with multi-lateral lenders like the IMF," Hasnain Malik, equity strategist at Exotix Capital, said.
The Turkish lira sank to its lowest levels since 2001, roiling global markets on Friday, as tensions flared between Nato allies Turkey and the United States over Ankara's imprisonment of an American pastor.
On Friday, US President Donald Trump doubled tariffs on Turkish metal imports.
Retorting to Mr Trump's move, Turkish President Recep Tayyip Erdogan urged the country's citizens on Saturday to support the lira, to win a "war of independence".
“If there are dollars under your pillow, take these out. If there are euros, take these out. Immediately give these to the banks and convert to Turkish lira and by doing this, we fight this war of independence and the future. Because this is the language they understand,” he said.
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If Turkey fails to take decisive measures, it will face a significant risk of a banking crisis, as both government and corporate borrowers rely heavily on foreign debt, analysts said.
"The longer this crisis goes on without a serious policy response, the higher the odds of a banking crisis. At the very least, I expect some individual banks will fail," said Win Thin, a strategist at Brown Brothers Harriman & Company in New York . "I would assume that the government would step in to take over banks that are too big to fail. Either way, lots of pain ahead in the banking sector."
The financial turmoil is showing signs of a spillover into the rest of the economy. The falling currency will make imports more expensive and stoke inflation.
"The sectors that will suffer the most are those which rely on imports," said Ghanem Nuseibeh, founder and director of Cornerstone Global based in London.
“This includes in particular the energy sector, but also construction.”
This creates a problem for Turkey. It is heavily reliant on importing oil, which is priced in dollars, a currency that has been rising this year while the lira weakens.
Turkey will need to implement a number of measures to stem its financial meltdown, "none of which will be easy to deliver politically" and "none will be easy to sell economically," Mr Nuseibeh said.
An aggressive interest rate rise by the central bank of at least 10 percentage points is a minimum start, analysts said.
However Mr Erdogan, who has described interest rates as the “mother and father of all evil”, has been traditionally set against the move.
Economists say the central bank needs a hefty increase in rates for an extended period to tackle inflation and to shed the perception that it lacks
independence.
Turkey needs to improve international relations with the European Union and the US to ease tensions with the West and calm markets, they said. “If Turkey could fulfil these conditions, then the IMF might consider giving Turkey a programme but, to me, I doubt Erdogan will do this except as a last resort,” Mr Thin said.
"The lesson from other countries that have suffered from currency crises is that fiscal and monetary policy will need to tighten, preferably under the auspices of an IMF deal, to stabilise the economy," according to an August 8 report by Capital Economics.
“Our concern is that there is little appetite within the Turkish government or central bank to tighten policy, let alone turn to the IMF for support.”
Turkish policymakers will try to “muddle through for as long as possible,” resulting in higher inflation and a weaker lira, the report said.
The alternative measures of capital controls, blaming foreign powers for the crisis and sticking to the pursuit of high growth via “unjustifiably low” interest rates will deepen the crisis, Mr Malik said.