Turkey's currency drops to record low on Russian missile defense tensions with U.S.

Key Points
  • U.S. sanctions against Turkey "are becoming a distinct possibility," one analyst told CNBC.
  • Washington on Wednesday issued a stern rebuke in response to reports that Turkey was preparing to test the Russian S-400 missile defense system.
  • In addition to the pandemic, Turkey is facing double-digit inflation and mounting unemployment, and a ballooning current-account deficit. 
Turkish Lira
Mehmet Kalkan

DUBAI, United Arab Emirates — Turkey's currency dropped to a historic low on Thursday, with the U.S. dollar buying 7.942 lira by late afternoon in Istanbul.

The move is the latest in more than two years of consistent depreciation of the Turkish currency, most recently intensified by Ankara's involvement in a slew of geopolitical conflicts including Libya and Nagorno-Karabakh, eastern Mediterranean resource disputes and its purchase of Russia's S-400 missile defense system. 

Washington just on Wednesday issued a stern rebuke in response to reports that Turkey was preparing to test the S-400 system, purchased from Russia despite vocal opposition from the U.S. and the rest of Ankara's NATO allies. Turkey's defense ministry has not commented on the reports, but condemnation from the State Department was swift.

"We … are deeply concerned with reports that Turkey is continuing its efforts to bring the S-400 into operation," the State Department said. "We continue to stress at the highest levels that the S-400 transaction remains a major obstacle in the bilateral relationship and at NATO, as well as a risk for potential … sanctions." 

Sanctions becoming a 'distinct possibility'

Tensions with the U.S. and the threat of sanctions have contributed to the lira's plunge in the past, including during Turkey's 2018 recession. Fast forward to 2020 and the country of 82 million is involved in fresh conflicts while fighting a pandemic that has crippled its vital tourism industry, as well as facing a ballooning current-account deficit, double-digit inflation and mounting unemployment.  

A Russian S-400 surface-to-air missile system.
Sergei Malgavko | TASS via Getty Images

"Ankara is left between a rock and a hard place, and has no easy way out of any of the conflicts it finds itself embroiled in for fear of appearing weak domestically or internationally," said Agathe Demarais, global forecasting director at the Economist Intelligence Unit. 

"There is therefore little chance that Turkey will seek to assuage tensions in any of the conflicts it is a major player in. In turn, this means that more lira volatility is on the cards."

U.S. sanctions against Turkey "are becoming a distinct possibility," Demarais warned, noting the potential headwinds facing Turkey if Democrat Joe Biden wins the U.S. presidential election. "Under a Biden administration, the U.S. would also be expected to take a harder stance against Turkey. If the U.S. goes ahead with sanctions, a repeat of Turkey's 2018 financial crisis appears possible, and would derail the post-coronavirus economic recovery."

Geopolitical tensions are only part of the story

But geopolitics is just one part of the story, said Erik Meyersson, senior economist at Handelsbanken Macro Research in Stockholm. 

"Turkey's financial problems are deeper, and related to the changes in political institutions — in other words the degree to which the country has become more authoritarian," he told CNBC. This has manifested itself in the form of more intervention into central bank policymaking by President Recep Tayyip Erdogan and less independence for financial institutions as a whole, which has weighed heavily on investor confidence.

Turkey's President Recep Tayyip Erdogan (L) and Russia's President Vladimir Putin shake hands at a joint news conference on Syria following their meeting in Sochi, Russia.
Mikhail Metzel | TASS | Getty Images

Turkey's central bank did surprise investors by raising its main interest rate in late September from 8.25% to 10.25%, a move contrary to the president's calls to keep them low.

"Economic agencies are not autonomous in setting broader economic policy. As such, you get too much focus on short-term, credit-driven growth as opposed to more structural efforts toward raising the longer-term growth," Meyersson said. 

The Turkish Directorate of Communications and the Office of the Presidency did not respond to a CNBC request for comment.  

Turkey's consumer inflation was revealed at 11.75% year on year for September, slightly lower than analyst estimates "but hardly encouraging still" as "core (inflation) pushes higher," Timothy Ash, senior strategist at Bluebay Asset Management, commented on Monday. Slower-than-expected price increases of goods for last month helped offset the blow of the steadily weakening lira.

But with a central bank under pressure from Erdogan not to raise interest rates that would help curb inflation — and with no end to geopolitical tensions on the horizon — the impact of the lira's fall is likely to become more pronounced, analysts said.