Erdogan’s dream of Pan-Turkism is turning into a nightmare for foreign investors.
Turkish President Recep Tayyip Erdogan is not usually known as an economic innovator, says Chris Miller of Foreign Policy. But for the past year, his government has been running a high-stakes economic experiment. The test: How long can Turkey hide the fact that it is spending far beyond its means? Normally when governments spend more than they tax, the difference appears as a budget deficit. They fund that deficit by issuing bonds, which are traded on international markets and so are easy to track. If the debt load grows too large, and if borrowing costs spike, then the country must default or seek a bailout. This type of debt crisis isn’t pleasant, as Argentina or Greece or Pakistan could attest, but it is at least straightforward and familiar.
Turkey has also spent well more than it should, but it has done so in a way that hid the costs deep in its financial system, leaving them invisible to all but the most committed financial sleuths. There’s relatively little sovereign debt. The big borrowing has been by the country’s banks, including both private and state-owned banks which funded Erdogan’s expansionist ambitions. However, the country still needs capital to operate internally and with lack of monetary resources, there is no other option but devaluation of its own currency. And that’s where the problem begins.
To raise the needed capital, Turkey has offered several high yielding bonds to the international markets with the latest $2.5b, 6.375% 14oct2025, USD bond. But who buys and owns these bonds? According to the IMF, the EU has the most exposure to these bonds and therefore Turkish Lira which has plummeted 33.36% year to date.
The head of macro strategies at Record Currency Management, which oversees $63 billion in assets, is shorting government bonds of Spain, France and Italy — as well as the euro itself — on the expectation that Turkey’s market ructions will soon be felt on the balance sheets of European banks. Foreign bank exposure to Turkey has fallen since the 2018 currency crisis, but overseas lenders still had a total of $166 billion of claims on Turkey at the end of 2019, with European banks accounting for the lion’s share, according to data from the Bank for International Settlements. In the chart below, we can see the massive money outflow from Turkish bonds.
“Nobody wants to buy long-dated bonds in Turkey anymore. It’s one of the signs of stress,” said Jan Dehn, head of research at Ashmore Group, who has sold Turkish debt holdings in recent years. Regardless of this outflow, the size of EUs exposure to Turkey is threatening for bond holding nations such as Spain, France and Italy. These countries were hoping for more QE and fiscal policies from the IMF to recoup some of their losses.
There’s an old banking proverb: “If you owe the bank thousands, then you have a problem. If you owe the bank millions, then the bank has a problem.” The proverb is also given as: “If you owe the bank thousands, then the bank owns you. If you owe the bank millions, then you own the bank.” And Erdogan is well aware of this! He uses EUs exposure to Turkish bonds to enforce a deadly neutrality and silence towards Turkey’s crimes against humanity.
No one knows for how much longer can Erdogan play this game, but one thing is for certain, the risk of a disastrous outcome is increasing.