Experts are predicting a recession for Turkey next year. Here's what you need to know

  • Alongside a downgrade from ratings agencies Moody’s and S&P moving Turkey’s debt closer to junk territory, experts now predict a recession within the next year.
  • The lira’s rollercoaster moves have knocked hundreds of points off global markets in single days, and triggered sell-offs across emerging economies.
  • One year ago, a dollar bought roughly 3.5 lira. On Monday, it bought more than 6.
A supporter of Turkish President Recep Tayyip Erdogan waves a flag against an electronic billboard during a rally in Kizilay Square on July 18, 2016, in Ankara, Turkey.
Chris McGrath | Getty Images
A supporter of Turkish President Recep Tayyip Erdogan waves a flag against an electronic billboard during a rally in Kizilay Square on July 18, 2016, in Ankara, Turkey.

The road ahead for Turkey isn't pretty.

Alongside downgrades from ratings agencies Moody's and S&P moving Turkey's debt closer into non-investment — or junk — territory, experts now predict a recession within the next year.

"The downgrade reflects our expectation that the extreme volatility of the Turkish lira and the resulting projected sharp balance of payments adjustment will undermine Turkey's economy," S&P Global Ratings said in a statement Friday. "We forecast a recession next year."

A recession in the country of 80 million, which sits at the crossroads of Asia and Europe and is home to both NATO's second-largest military and more than 3.5 million Syrian refugees, would be no small event.

The lira's roller-coaster moves have knocked hundreds of points off global markets in single trading days, and triggered sell-offs across emerging markets. Turkey comprises 1 percent of global gross domestic product (GDP) and has been making headlines most recently for its heated spat with Washington, with whom it has traded sanctions and tariffs.

Where did it start?

The root causes of Turkey's ongoing currency crisis are domestic, experts say, despite recent jolts from U.S. sanctions and tariffs issued over Ankara's detention of American pastor Andrew Brunson, held since 2016 on espionage charges he denies.

Prolonged economic overheating, concerns over central bank independence, faulty monetary policy holding down interest rates amid soaring inflation, a gaping current account deficit and heavy external debt have coalesced over several months to pull the country into what analysts have called "a hole of its own making."

Turkish President Recep Tayyip Erdogan has long pressured the central bank against monetary tightening, calling himself "the enemy of interest rates" as he prioritized rapid growth over tempering runaway inflation, currently at more than 15 percent.

This led the lira to spiral over time, as investors lost faith in the country's fiscal discipline. One year ago, a dollar bought roughly 3.5 lira; on Monday, it bought more than 6.

S&P Global Ratings predicts an economic contraction in 2019, thanks in large part to the deep hit to the lira — a roughly 40 percent depreciation against the dollar since the beginning of the year — "really putting a lot of pressure on a private sector that is highly indebted in foreign currency, particularly the corporate sector," Roberto Sifon Arevalo, head of sovereign analytics and research at S&P Global Ratings, told CNBC on Monday. Foreign currency-denominated corporate debt equals about 50 percent of Turkey's GDP.

Next at risk are Turkey's banks, which provide a lot of that financing, Arevalo said. "When you add all these conditions — the availability of foreign exchange financing, added with the response from the government, this is a combination that means it will take longer for Turkey to find its way and will impact economic growth, hence our forecast."

No long-term plan in sight

While banking authorities have attempted short-term fixes for the lira, like pledges of liquidity for banks and a halt in offshore currency swaps to stem lira short-selling (traders betting against the currency), the government largely lacks a broader recovery plan. Instead, Erdogan has blamed the U.S. for waging "economic war" against Turkey, likening its "attack" on the lira to attacks on Turkey's flag or the Islamic call to prayer. Warnings of potential further sanctions by the U.S. Treasury on Ankara have only thrown more uncertainty over the country's financial trajectory.

Erdogan's nationalist bombast may be working among the large proportion of Turks who support him, but it has only further perturbed investors. Last week saw the yield on five-year local currency bonds spike more than 250 basis points to a new record, and the benchmark BIST stock market index led global losses.

The lira, which has rebounded from the record low of 7.24 it hit against the dollar on August 13, slipped by 1 percent on the news of the ratings cut, a move from "BB-" to "B+." It was trading at 6.1192 to the greenback at 3:50 p.m. Istanbul time (10:50 a.m. ET) Monday.

Running out of time

Turkey's already untenable inflation "will peak at 22 percent over the next four months, before subsiding to below 20 percent by mid-2019," S&P reported as part of its downgrade, highlighting the pressure ahead for Turkish consumers.

While many economists say that contagion to other emerging markets and European banks will be limited, the worst may be yet to come, as market observers see no relief measures in sight from a government choosing to double down rather than de-escalate and heed the advice of worried experts.

Still, it's "common sense" to assume the crisis will calm, said Christopher Granville, managing director of global political research at TS Lombard in London. "If you look at Erdogan's track record, he does tend to back down in the end, although it takes time," he told CNBC's "Squawk Box Europe" Monday.

But even the resolution of political tensions with the U.S. wouldn't solve Turkey's problem on its own from an investor point of view, "though of course it would help on the margin," Granville added

"Some political resolution is likely but that's not very helpful advice for investors," he said. "Because that takes a long time, which Turkish markets don't have."