The U.S. imposed financial sanctions on two key Turkish minsters August 1, blocking any U.S. transactions and assets for the ministers of Interior and Justice on grounds of continuing to imprison American Minister Andrew Brunson. Unsurprisingly Turkish assets especially the lira, sold off sharply on the announcement as uncertainty around sanctions reinforces other pre-existing stresses on Turkey’s external balance. This note takes a look at some key things to watch in the coming days and weeks regarding the bilateral relationship, Turkish economy/financial markets and the U.S. policy towards Russia and Iran.
While further escalation, especially broadening of sanctions in terms of scope and target would be negative for Turkey, the biggest concerns remain around domestic policy, including that of the central bank, the banking system and any potential quasi-fiscal stimulus that might continue the boom and bust approach. The measures add to the implementation risk around existing sanctions programs in Iran and Russia (two countries that are major suppliers of fuel to Turkey), both of which may suffer from a disconnect between political proponents and implementing agents.
The measures, which were taken under the auspices of the global Magnitsky act, were targeted to officials directly involved in the captivity, and are the latest step of an escalation of diplomacy publically and privately, as US officials including Vice President Pence have called for Brunson’s release. It seems designed to send a message to Turkish officials especially Erdogan himself who increasingly calls the shots across a wide swath of policy areas – itself a challenge to Turkey’s economic management.
This is not the first time a Turkish entity has been targeted, Turkish banks engaged in trade with Iran, Russia and Iraq have previously been caught in the cross-fires. However targeting the ministers of a NATO ally is unprecedented. The sanctions while meaningful for the individuals, are an important symbol for the country, a NATO ally and reflect the deterioration of the bilateral relationship. Unlike measures on Russia, which the administration cited as “a model’, the measures target individuals not broad sectors or state banks, and are at least for now much more targeted. As with Russia in 2014, ongoing BOP and financing dynamics may amplify the effect and provide a useful excuse for continued policies locally, providing more credence to arguments about an external actor threatening.
Market response was a knee-jerk sell-off – unsurprisingly, investors tend to sell first assess exposures later. The steady- as- she-hikes statement from the Fed released at almost the same time as the sanctions designation may have contributed to this. Sanctions aim to increase the perception of risk of a given entity to prompt policy change. The financial exposure of the individuals may not be large, but the concern is around the direction of travel of sanctions measures and of increasing Turkish posturing regarding retaliation.
Some scenarios: Headed towards a Summit and Grand Bargain? Or Will it just escalate?
De-escalation in the coming days perhaps around some sort of bilateral discussion. Turkish officials had previously moved Brunson to house arrest. The escalation and pressure seems par for the course of increasing pressure before trying to strike a deal/grand bargain, possibly including some promises on Iran. The track record on these deals has not so far been great but such a measure could buy time. These might not hold, given long-standing Turkish interests in the region, but could allow a greater focus on the issues themselves.
Escalation, at least rhetorically, involving the broadening of sanctions, to what many in the U.S. policy world have seen as increasing malign behavior. This could be damaging both to Turkey’s finances (exacerbating the local policies) but also complicate other regional policies.
Its hard to see a truce lasting as distrust grows. A formal rupture may be unlikely, but net result may be to further increase Russia’s influence in the region.
Some Political and Economic Areas of Concern
The speed of implementation and risks of escalation raise risks of collateral damage. Although the targets may have been considered for some time, and may not have much international exposure, global banks are likely to be assessing a wider range of actors in Turkey for counterparty risk.
Impact on other policy areas: Even if the sanctions succeed in their proximate target (the release of American minister Andrew Brunson) they may complicate other priorities including the implementation of energy sanctions on Iran (see my latest on the topic here with CNAS colleagues) and other regional issues including Syria, Iraq. More on this can be discussed below.
Mission creep? One thing to watch is whether sanctions remain contained to the issue, or whether there is a degree of mission creep – ie whether sanctions are considered for a wider range of bilateral irritants, including other topics (support of regional actors including in Syria), trade relationships with Iran, beyond their initial scope. Doing so might make the current case seem less arbitrary, but also might complicate the effectiveness of the tools and regional policy. In particular, it might make it hard to remove even if initial requirements are met, might make it harder to achieve regional peace and security. This has been a trend across many jurisdictions receiving sanctions.
Domestic economic issues: Domestically, the move may reinforce the view of those that believe Turkey is subject to foreign plots including in the FX market, providing an excuse or justification for more inward focused stimulus. If so, this would likely put additional pressure on the currency, force the central bank into more belated and half-hearted hiking and exacerbate the slowdown from last year’s sugar rush of overstimuluative policy.
Turkish financing issues reflect is sizeable current account deficit, reliance on short-term capital flows, exposure to rising energy costs, that isn’t reflected in local rates. Turkish authoirties tendency to keep policy as easy as possible on liquidity standpoint tightening only when sharp drops in the lira require it, and lacking sufficient reserve buffers, leave it vulnerable to shifts in global financial conditions. Given the Fed stance to continue hiking rates, re-iterated in the August 1 business as usual meeting, the global environment looks unlikely to turn more supportive. Sanctions and fear of further escalation would only make this financing environment more difficult, but the domestic policy uncertainty is the cause, rather than sanctions, especially since local markets are already pricing in significant risk.
What does it mean if anything for the ongoing sanctions on Iran and Russia?
The deterioration in bilateral relations have complicated efforts to convince Turkey to cut oil and natural gas imports from Iran. As with other counterparts, there are signs that Turkish entities have moderated their purchases, largely due to concerns about access to financing, but politically, they have been reluctant to accede. As a result, there is a meaningful risk that Turkish entities could look to become intermediaries for non-energy goods as some others.
A net result of any success in reducing Iranian exports to Turkey would likely result in a greater reliance on fuel from Russia, which took Iranian market share in Turkey in 2012-14 and has direct natural gas exports. The rift is also likely to reinforce divides in the GCC, given Qatar’s linkages with Turkey and to an extent Iran.
U.S. issues (politics ahead of midterms, implementation issues around existing sanctions and divergence within the administration are likely to be bigger factors for Russia sanctions than Turkish measures. However, it would be unsurprising if Russia took advantage of the rift. Already, the Senate is likely to pass new sanctions measures. Should those be mandatory for the administration, they might cause greater uncertainty on investment outlook for counterparties.
That all of these measures are being done unilaterally rather than with European allies may limit enforcement, and complicate the legal environment for a range of counterparties.
Ziemba Insights 