Turkey’s Economic Crisis: Does It Matter for the Eurozone?

Turkey is in deep trouble. After a credit-driven boom, the surge in Turkish inflation, bond yields and the even more dramatic plunge in Turkey’s exchange rate in 2018 suggest that the country could now be in danger of heading for a bust.

Beyond the obvious risks to Turkey itself, this raises the question of how much the Eurozone economy would be affected. The impact on Eurozone GDP growth would be small. Even if Eurozone goods exports to Turkey were to fall by, say, 20%, this would subtract no more than 0.1 percentage points from growth in the big Eurozone.

Turkey’s economy has been running hot over the last quarters. A large pre-election fiscal stimulus program, elevated credit growth and bad policy decisions have caused a major rise in inflation (rising to 15.8% year-over-year in July 2018, compared to 9.8% in July 2017).

Turkey is also experiencing a dangerous widening of the current account deficit (reaching about 6.5% of GDP in 2018).

In addition, direct pressure from President Recip Tayyip Erdogan on the central bank to keep interest rates low has further undermined investor confidence.

U.S. sanctions

The pressure on the Lira and Turkish bond yields have increased dramatically over the last four weeks due to the recently announced U.S. sanctions and fears of a further escalation to tit-for-tat between Turkey and the United States.

An apparent lack of urgency on the part of the Turkish government to react to the many economic dangers has not helped. Over the last 12 months, the Turkish Lira fell by about 33% versus the euro.

This decline undoubtedly helps the Turkish tourism sector, but spells trouble for the rest of the economy. The decline in the Turkish Lira and rising borrowing costs cause a big headache for many Turkish companies, as they have borrowed in foreign currency despite receiving revenues in local currency.

The credit-fuelled consumption boom of the past is unlikely to continue due to sky-high inflation, high debt levels and high borrowing costs. A temporary decline in GDP in late 2018 or early 2019 looks quite likely if the authorities do not restore confidence soon.

Even a recession and a debt crisis that would force Turkey to implement capital controls and ask for an IMF bailout cannot be ruled out anymore. Turkey now has much less room to kick the can down the road than before.

Potential repercussions on the Eurozone economy

Turkey’s economy grew by about 60% in real terms since 2009 and its annual GDP now amounts to about €750 billion. That is equivalent to 6.5% of Eurozone GDP. Turkey’s GDP is four times larger than that of Greece, but less than half the size of the Italian economy (despite Turkey having a larger population, at about 80 million compared to roughly 60 million for Italy).

The Eurozone runs a goods trade surplus with Turkey. Last year, the Eurozone exported €63 billion of goods to Turkey. Goods imports from Turkey reached €50 billion last year. Furthermore, Eurozone countries’ exports to Turkey have risen by 80% since 2009.

Imports accelerated even faster, by 88%, during the same time period. However, Eurozone exports to Turkey have declined slightly since 2012 relative to Eurozone GDP. They amounted to just 0.57% in 2017.

Lessons from previous crises

Turkey has suffered two major economic crises in the last 20 years. In November 2000, the IMF had to bail out Turkey after a boom had turned to bust. In 2001, Turkey’s economy contracted by 6% with Eurozone exports to Turkey plunging by 30%.

In 2009, Turkish GDP fell by 5% in response to the fallout of the global financial crisis. At the same time, Eurozone exports to Turkey declined by about 20%.

If Turkey were to fall into a comparable crisis again, a drop in Eurozone exports to Turkey by 20% or 30% could directly deduct between 0.1 and 0.15 percentage points from annual Eurozone GDP growth.

However, as seen in previous external setbacks such as the 2014 sanctions imposed on Russia, Eurozone companies are pretty quick in identifying and switching to new markets.

Selling more elsewhere would offset some of the hypothetical decline in Eurozone exports to Turkey. After the 2001 crisis, it took only 2 years for Eurozone exports to Turkey to reach previous highs.

EU contagion risks from a Turkish banking crisis

Of course, a full-blown Turkish banking crisis would have some negative repercussions on Eurozone banks that have large credit exposure to Turkey or own Turkish banks. The total exposure of banks in the three Eurozone countries with the largest claims in Turkey is about $135 billion (Spain $81 billion, France $35 billion and Italy $19 billion), according to the BIS.

That the fallout from a potentially significant banking crisis in Turkey could cause any credit crunch in any part of the Eurozone seems highly unlikely.

Potential political fallout

Migration: A deep Turkish recession could lead to more migrants leaving Turkey for the EU. Currently more than three million Syrian refugees are living in Turkey.

A large increase in migrant arrivals in the EU could strengthen support for right-wing radical parties in the EU. Despite disputes between Turkey and the EU on many issues, the EU has a strong interest in a stable Turkey.

Economic policies: At the margin, the Turkish crisis could discredit unorthodox economic policies in Europe and elsewhere. The Turkish example shows that bad or unconventional economic policies have long-term negative consequences and make a country more dependent on the political goodwill of others.

Whether or not policy makers elsewhere will heed such a lesson is a separate question, though.