As Turkey’s currency continues its free fall and the crisis begins to spill over into European and emerging markets, here is what you need to know about how we got here and what the consequences could be.

Why is Turkey’s currency collapsing?

Turkey’s currency crisis has intensified over the last few days because of punitive tariffs announced by Donald Trump on Friday. In a tweet, the US President revealed that his administration would be hiking tariffs on Turkish steel and aluminium to 50 per cent and 20 per cent. In response, the Turkish lira fell by as much as 20 per cent against the US dollar and eventually reached an all-time low over the weekend. After bouncing back slightly over night, it is down by around 7 per cent against the dollar today, settling at 6.87 lira to the US dollar.

However, the causes of Turkey’s economic woes go far wider and deeper than simply an escalating trade war with the US. Turkey’s rapid economic growth in recent years has been driven by foreign-currency debt, which the IMF predicts now stands at more than 50 per cent of Turkey’s GDP. All this borrowing has meant the country has been operating both fiscal and current account deficits. Without the reserves to fall back on, Turkey has left itself particularly vulnerable.

As much as 39 per cent of the national debt is denominated in US dollars. As the economy has been allowed to overheat, inflation has reached an alarming 15 per cent (the central bank’s target is 5 per cent) and possibly higher.

Markets have been spooked by the government’s management of the economic challenges it faces. After seizing greater presidential power in a referendum last year, Erdogan placed his son-in-law at the helm of the finance ministry and together they have resisted any attempts by the central bank to raise interest rates, opting for accelerating economic growth instead. Nor have they sought to tighten fiscal policy, government taxation and spending, as many investors would like them to. As a result, no action has been taken to stem the falling value of the lira (the worst performing currency this year, having depreciated by more than 40 per cent against the dollar), to reduce the current account deficit, or to diminish the country’s dependency on foreign money. Money continues to flood out of the country.

With Erdogan behaving increasingly dictatorially in his pursuit of unorthodox economic policies, undermining the independence of the central bank in the process, there is little chance of him restoring the trust of the markets anytime soon.

Why is the US gunning for Turkey? 

Relations between the two nations have been deteriorating for some years, dating back to a dispute during the Iraq war. Tensions grew further in 2016 during the aftermath of the attempted coup against Erdogan. Writing in the New York Times on Friday in response to Trump’s tariff announcement, the Turkish President expressed his disappointment at America’s failure to unequivocally support his government at the time. He has also been angered by the refusal of both Obama and Trump to extradite Fethullah Gulen, an influential Turkish cleric living in Pennsylvania, who Erdogan accuses of instigating the rebellion.

And it is from this coup that the most recent dispute originates. The Trump administration is demanding the release of Andrew Brunson, an evangelical pastor from the US who has conducted missionary work in Turkey for more than 20 years. He has been detained by the Turkish authorities since 2016 on accusations of involvement in the failed coup. Brunson denies the charges but could face 35 years in prison if found guilty.

Mike Pence and Mike Pompeo, America’s Vice President and Secretary of State, are both evangelical Christians, as are a significant chunk of Trump’s core base. This is an important case for the Trump administration and one they will continue to push hard on.

How is Erdogan responding to the crisis?

Erdogan is refusing to give in to pressure from Trump, despite the growing financial cost. In another speech today, he accused America of trying to stab Turkey in the back.

What’s more, he is refusing to bow to market pressure to change his economic policies, including on interest rates. He blames Turkey’s economic turmoil on foreign attackers, arguing it has nothing to do with domestic economic mistakes.

The central bank announced limited measures this morning, promising to provide “all the liquidity the banks need,” what central banks under pressure always say. However, the only solid way to rescue the situation is through an interest rate rise, to strengthen the lira and curb inflation.

Aren’t Trump and Erdogan, two strongmen, supposed to get on? 

Initially, relations between the two leaders were positive. However, this all changed rather dramatically when negotiations over the release of Andrew Brunson broke down. Trump thought, mistakenly, he had a deal with Erdogan and so trust between the two leaders has evaporated.

As two strongmen posing as powerful leaders, vigorously defending their country’s interests, neither will be willing to back down in response to threats and both will be determined to come out on top. Just as Trump will hope to be cheered on by his core supporters, Erdogan’s desire to be seen as standing up to American bullying is likely to outweigh his concern with Turkey’s deteriorating financial position.

Can Turkey get the money it needs ‎from alternative sources such as Qatar, Russia or China? 

Possibly, but it is difficult to see how it can get all it needs. Furthermore, all three countries will be reluctant to aggravate America by coming to Turkey’s rescue. China is in the middle of a trade war with Trump. Russia is struggling with US sanctions itself. What’s more, Qatar hosts the largest US military base in the Gulf (much larger than the US presence in Turkey). Qatar, seeking to shake off sanctions itself, hopes for American backing in its dispute with its neighbours in the region.

Could the crisis have global ramifications?

It already has. The Euro is at a yearly low and European bank shares dropped today. The three largest Turkey-exposed European banks; Unicredit, BBVA and BNP Paribas, have been worst affected.

Emerging markets have also been hit, with currencies such as the South African rand and Indian rupee experiencing significant depreciation.

Agathe Demarais, Turkey analyst at The Economist Intelligence Unit, foresees Western banks being hit by Turkey’s currency collapse in the near future:

“Within a few months western banks that have strong ties with Turkey will feel the impact of the crisis as Turkish corporates will struggle to repay debt in foreign currency”.

Conclusion

In short, this crisis looks set to get worse before it gets better. Not only will it disrupt global markets, the geopolitical fall out could also be significant.