Things are getting ugly in Turkey – what does that mean for global markets?

Turkey has looked like a disaster waiting to happen for a little while now.

President Recep Tayyip Erdogan has steadily transformed a functioning democratic economy into an autocratic mess.

But now things are really coming to a head. A spat with the US over the arrest of an American citizen has resulted in minor sanctions being placed on two Turkish politicians.

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For a less vulnerable economy it might not matter.

But for Turkey, it appears to have been the last straw.

Turkey's classic mistake spending too much money

The Turkish lira has been sliding for most of this year but now it's in full-on collapse mode. It's seen a double-digit fall against the US dollar this morning, and is now down something like 35% or more in the year to date.

Turkish government debt, maturing in ten years and priced in lira, is now yielding more than 20%. This implies that investors are worried about default or soaring inflation, or both the latter because a collapsing currency pushes up prices, which are already rising at a rate of more than 15% a year.

Meanwhile, Turkish US-denominated debt of the same maturity now yields nearly 8%, which is more indicative of default worries. Turkish inflation wouldn't affect that debt directly but the currency collapse does make it harder to repay, because lira now buy fewer dollars.

And just to throw this into the mix it now costs more to insure against a Turkish government default than at any point since 2009.

So what's the big issue in Turkey?

The proximate cause is a dispute with the US over a detained American evangelical preacher. This has led to fears that the US will impose heftier sanctions on Turkey.

But this in itself has only become a big issue because the economy is in such a precarious position. And the reasons behind that are the usual ones Turkey lives too far beyond its means, and no one now trusts the government to respond in a sensible manner.

As William Jackson of Capital Economics puts it: "there are many factors that explain Turkey's current economic problems, but at the heart lies overly-loose monetary and fiscal policy".

In other words, interest rates have been too low and the government has been spending too much money. As a result, it is very dependent on foreign capital continuing to flow into the country. When those flows slow down or reverse as is happening now then it runs into trouble.

Erdogan is not in the mood to do what's necessary

What's the solution? In short, you need to regain the confidence of the market. You need investors to believe that you're going to take charge and start acting like a grown-up economy.

Normally, that would mean raising interest rates (sharply) and stopping spending so much money. And at this stage, turning to the International Monetary Fund (IMF) is also an option.

Those are the sorts of things that would improve confidence and probably put a floor under the currency crash. However, it's pretty clear that Erdogan is not going to suddenly turn into a sensible global citizen.

Instead he'll do what dictators always do he'll blame some sort of grand conspiracy (this, incidentally, is why the rise of the accusation "fake news" are so disturbing in the US). For example, here's what he said to supporters on Thursday night, reports the FT: "If they have dollars, we have our people, our righteousness and our God."

In other words, blame speculators, not the government.

This suggests, as Jackson puts it, that "there is little appetite within the Turkish government or central bank to tighten policy, let alone turn to the IMF for support".

So clearly the risk is that the lira continues to fall, driving inflation higher and making it ever harder for Turkey to repay its debts especially any debts denominated in foreign currencies.

It's also a problem for the Turkish banking sector. Foreign loans (ie, money loaned out in foreign currencies) makes up about 40% of the Turkish banking sector's assets, according to the FT. If the lira continues to slide, then corporations (it's mostly corporations) won't be able to repay those debts. That could be very bad news for the Turkish banks, too.

Could Turkey's economic woes could spread beyond its borders?

This is where it gets tricky, and the potential for a knock-on effects comes in. The European banking system is still one of the more vulnerable points in the developed financial system. The clean-up job got started a lot later than in the US or the UK, and in some cases, the nettle hasn't really ever been grasped as tightly as it should have been.

And of course, various eurozone banks (unsurprisingly, given its proximity) have quite a bit of exposure to Turkey themselves. The main ones in the spotlight today are Spain's BBVA, Italy's Unicredit, and French bank BNP Paribas.

Is their exposure big enough to cause a major problem? The good news is that it probably isn't. And so far, it also seems unlikely that Turkey's woes would spread to emerging markets generally souring sentiment is a potential issue, but Turkey's problems are pretty much unique to Turkey. So this probably isn't a repeat of the 1997 Asian crisis, for example.

However, while Turkey is not a major global player economically, it's not exactly insignificant either. If this situation deteriorates further and that seems very likely then it's hard to gauge exactly which dominoes could topple. So we need to watch it closely.

Oh, and needless to say this isn't a buying opportunity. Not yet.