Europe Economy

Turkey: What’s going on and why you should care

Turkey expected to hike interest rates

Turkey has slipped alarmingly quickly from emerging market darling to market danger zone – and the emergency meeting of its central bank Tuesday evening is the latest attempt to stem an investor exodus.

Local investors have been selling off their lira in favor of foreign currencies, and international investors have been staying away from the lira, pushing its value down to a record low of 2.3616 against the U.S. dollar. The cost of Turkey's debt is also rising alarmingly quickly, with 10-year debt hitting 10.45 percent, its highest since 2010.

Investors will be watching Turkey's central bank Tuesday to see if it yields to market pressure and increases interest rates in an attempt to buttress the lira.

The bank is holding its first extraordinary monetary policy meeting since the summer of 2011. It said there will be a statement on the outcome of that meeting at 5pm ET Tuesday.

Turkish central bank 'needs to tighten': Pro

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If the lira's fall is not halted, Turkish companies, which hold around $160 billion worth of currency reserves, could be devalued as a result – which is why the main equity markets are down around 5 percent this year.

Turkey's current problems stem from a corruption investigation which has led to the resignation of three ministers in Prime Minister Recep Tayyip Erdogan's government, and top-ranking police officers. Erdogan, leader of the AKP party, has argued that the accusations of bribery and money-laundering stem from his former supporter, the influential Muslim cleric Fethullah Gülen, who is based in the U.S.

Up until recently, Erdogan's government, which has lasted for 11 years, was seen as a beacon of free-market stability, although its more religious bent has alarmed some – secularism is one of the founding tenets of the modern Turkish state. Erdogan had seemed a shoo-in as president in elections scheduled for later in 2014, which would have kept him in power after his term as PM expired.

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Gulen is the kind of figure around whom conspiracy theories abound. These have been fueled by Erdogan's recent warning of a "parallel state" within the Turkish state, run by Gulen supporters in the military, judiciary and security forces.

Mustafa Ozer | AFP/Getty Images

Whether true or false, the allegations coming from both sides don't make a great investment case, and money has bled out of the country and the Turkish lira.

Turkey is not the only emerging market to suffer in recent weeks, with Argentina and Ukraine both punished for political turmoil and large current account deficits. Yet it is a substantially bigger economy than either of these, and World Bank projections suggest it should rise from the 17th biggest economy in the world in 2012 to the 14th in 2050. Its borders with Europe, Syria and Iran are another reason it is strategically important that a stable government and economy are in place.

Tuesday is one of the central bank's last chances to make a credible case for investing in Turkey in the short term.

"The market now wants plain vanilla central banking, with no further use of smoke and mirrors," according to Timothy Ash, head of emerging markets research at Standard Bank.

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Last week's so-called "back door" hike in interest rates -- when the central bank announced that the interest rate could rise from 7.75 percent to 9 percent on "exceptional" days -- only served to make investors more nervous about the secretive nature of the bank's action. Meanwhile, attempts to intervene in the lira's slide, by using Turkey's foreign currency reserves to buy up lira, have been unsuccessful.

A technical look at the Turkish lira

"The main problem is one of an erosion of foreign investor credibility in central bank policy, which has translated into too low real interest rates coupled with a wide current account deficit by international standards," Simon Quijano-Evans, head of emerging markets research at Commerzbank, told CNBC.

"Investors will begin to lose confidence at an exponential pace if the CBT fails to significantly hike the whole rates corridor now."

Currency market players are expecting interest rates to rise from 7.75 percent to 10 percent at the meeting, which will begin at midnight in Istanbul.

The central bank could also impose capital controls to stop people taking their money out of the country, George Magnus, a senior economic adviser at UBS, pointed out. Capital controls are criticized by free-market devotees, who argue that the freedom of movement of money should be preserved.

"In Turkey's case what is clear to me is that this administration, above everything else, is committed to free markets, and would go out of its way to avoid such a scenario," Ash argued.

- By CNBC's Catherine Boyle. Twitter: @cboylecnbc.