Turkey and the U.S. are embroiled in a visa spat that's hammered the lira. While the short-term market stress has inflicted considerable strain on Europe's gateway to the East, in the longer term both sides have ample reason to patch things over. But that will not be the end of Turkey's market troubles.
The Turkish currency was as much as 6 percent lower versus the dollar on Monday since both nations suspended visa services for each other's citizens over the weekend.
This is just a bad day in a series of bad months. The lira is the lowest since April, when President Recep Tayyip Erdogan won a referendum that was characterized by so much violence, and extended his powers and eliminated checks on his authority to such an extent, that European leaders said it created human rights concerns and jeopardized the country's progress toward European Union membership. Timothy Ash, analyst at Bluebay Asset Management, said the current dispute raises questions about Turkey's NATO membership.
While the market reaction to the visa row has been savage, this is the direct result of the lack of liquidity that occurs with persistent turmoil. As Turkey's problems have mounted there has been a higher requirement for banks and investors to reduce their exposure -- with very few new market entrants keen to take on Turkish risk.
It's not just diplomatic issues that are weighing on the currency. The lira has sold off 10 percent against the dollar in the past month as inflation gained and expectations rose that the Federal Reserve would raise rates before the end of the year. The greenback's momentum seems to be building. A firm U.S. employment report on Friday has pushed the probability for another Fed hike this year over 80 percent.
This is bad news for Turkish banks. The domestic lira interbank market is relatively small, so lenders have traditionally funded abroad, and in dollars. A weaker currency versus the greenback not only raises funding costs, it also squeezes access to liquidity.
Even though the U.S. probably doesn't care very much about a few visas, in the longer term both sides have a lot of skin in the game. The cornerstone of the American military presence in the Middle East is its sizeable NATO bases in Turkey. A diplomatic patching-up shouldn't be too far away.
That is not likely to be anything other than a temporary sop for Turkey. A significant improvement in market conditions is not on the cards until President Erdogan alters his insistence that the sell-off is due to malevolent foreign influences, or abandons his argument that higher central bank rates can't control soaring inflation.
The Turkish economy is not in the happiest of positions. Inflation jumped above 11 percent last month, while Monday's industrial production report showed contraction in August, which pulled the yearly growth rate down to just 1 percent, well below estimates. And the country's 2.1 percent quarterly GDP growth rate may not be all that it seems. In his report "Turkey: Are You Kidding Me?", Commerzbank analyst Lutz Karpowitz argues the nation's official data is "more than questionable."
The Fed will not postpone a rate increase to protect Turkey, and the nation is increasingly untouchable for foreign investors. While the wider geopolitical game rages, it is the lira that will take the pain, putting the entire Turkish economy at risk.
--Gadfly's Mark Gilbert helped with charts
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.