The Lira Plummets Amid Bruised But Not Yet Broken US-Turkish Relations

Farid Hajili Analysis 13 August 2018
The Lira Plummets Amid Bruised But Not Yet Broken US-Turkish Relations

The U.S. and Turkey have a lot of big mutual problems - Iran, the Islamic State, Bashar Assad – to mention but a few. Yet they seem to be preoccupied by much smaller ones (pastors and alleged deep state operatives).

The Turkish lira has gone from steady decline to precipitous fall. It has declined roughly 40 percent since the beginning of the year and roughly 14 percent since the beginning of the day. Many have blamed this financial calamity on the Trump administration. After all, it has placed sanctions on a few Turkish officials, it has threatened to remove Turkey from a program that allows it to export some products to the U.S. duty-free, and just today, and it announced it would double steel and aluminum tariffs.

Over the past several years, relations between the U.S. and Turkey have deteriorated. Since the Syrian civil war began in 2011, U.S. support for the Syrian Kurdish People’s Protection Units, or YPG, which Turkey considers a terrorist organization, has caused a rift between the two countries. That rift was exacerbated by disagreements over Turkey’s purchase of S-400 air defense systems from Russia – which led the U.S. to suspend sales of F-35 multirole fighter jets to Ankara.

And this week, in response to Turkey’s 2016 detention of an American pastor on espionage charges, the U.S. imposed sanctions on two Turkish government officials. These circumstances and actions have caused serious tensions in their relationship, yet both countries still need each other in the long term.

Disagreements over Syria

Though Turkey has long opposed the United States’ support for the Syrian Democratic Forces, a large portion of which consists of the YPG, the issue really came to a head earlier this year after Turkey invaded Afrin, a Kurdish-controlled area in northwest Syria. Ankara sees the Syrian Kurds’ control of territory near its border as a threat, largely because Kurdish groups in Turkey have demanded autonomy for decades and carried out terrorist attacks that have killed tens of thousands since the 1980s.

Turkey then moved farther east toward Manbij, a city held by the SDF and in an area in which the U.S. had some of its own forces stationed. Reluctantly, Turkey refrained from moving into Manbij to avoid getting in direct conflict with a U.S.-backed force. After months of negotiations, the U.S. and Turkey reached a deal in early June: YPG military forces would withdraw from certain areas around Manbij, and the U.S. and Turkey would conduct “independent but coordinated” patrols around the perimeter of Manbij city.

The strength of the YPG force still in Manbij is unclear. In mid-July, Turkey said reports the YPG had completely withdrawn were “exaggerated,” adding that the process was ongoing despite the Manbij Military Council’s having claimed that the withdrawal was complete. But more important, Turkey isn’t satisfied with the YPG’s removal from the outskirts of Manbij in the first place – it wants all forces removed from Manbij city itself. The full details of the agreement reached in June haven’t been released, but from what we know, it permits Turkish patrols only outside Manbij and doesn’t demand the removal of YPG forces from the city.

Nevertheless, over the past several weeks, Turkish pro-government newspaper Daily Sabah has published reports indicating that U.S. and Turkish forces are cooperating in Manbij – a sign that, even if Turkey isn’t entirely satisfied with the current arrangement, it’s pleased that the U.S. is willing to come to some compromise on the issue.

Disagreements over weapons

Advanced weapons procurement has been another sore spot for U.S.-Turkish relations. Two weapons systems have been at the forefront of the dispute: the Russian-made S-400 air defense system and the U.S.-made F-35 Joint Strike Fighter.

Last December, Turkey finalized its deal to purchase the S-400 from Moscow. Its NATO allies say they’re concerned that the S-400 is incompatible with NATO systems. But in reality, they fear that the S-400 may be used against NATO members, particularly Greece, with which Turkey has an ongoing dispute over Cyprus. The U.S. also fears that Turkey’s use of both Russian and American defense systems could give Russia insight into how the F-35 works and reveal weaknesses in its stealth capabilities, which Russia could then exploit.

Given that nearly $500 billion has already been spent on F-35 development – in part to have a multirole fighter that can bypass air defense systems of other advanced militaries – this isn’t a minor concern. The U.S. has therefore moved to deny Turkey access to the fighter, at least for now. In late July, the U.S. House of Representatives and Senate passed a bill that suspended the transfer of F-35s to Turkey until a congressional committee completes a review of U.S.-Turkish relations (even as Turkish pilots began training in F-35s in early July at Luke Air Force Base in Arizona).

Since 2002, Turkey has invested a billion dollars in the F-35 project – a small sum compared to the U.S. investment but a considerable amount of money for Ankara. Turkish Aerospace Industries has also begun producing F-35 parts. The U.S. move to cut off Turkey from purchasing F-35s at this stage has, therefore, angered Ankara. Why, then, would Turkey go forward with the S-400 purchase? For starters, Turkey’s own air defense systems are aging, even though NATO does have more modern systems stationed in Turkey. Turkey was initially interested in purchasing U.S.-made Patriot batteries with PAC-3 interceptor missiles. But it sought greater technology transfer rights with the purchase than the U.S. was willing to give. After then considering Chinese systems, it settled on purchasing the S-400 from Russia.

Turkey may also be using the S-400 deal as leverage to convince the U.S. to allow the Patriot missile technology transfer. Indeed, in mid-July, the U.S. State Department said it was working with Turkey to sell Patriot missile systems to replace the S-400 purchase. Turkey acknowledged that it was considering a deal on the Patriot systems but said it would be a supplement to, rather than a replacement for, the S-400. Ankara has already committed to spend $2.5 billion on the S-400 deal, but it wouldn’t be surprising if Turkey considered withdrawing from it were the U.S. to agree to the technology transfer. After all, such a deal would give Ankara both an air defense system and the F-35, whereas Turkey would get only an air defense system with the Russian deal.

Turkey may also be trying to get both the Patriot and the S-400, which are of somewhat different classes of air defense systems. The S-400 is used to defend critical infrastructure and other domestic assets and has a much longer range than the Patriot, which is a midrange system.

Disagreements over an American pastor

Over the past several weeks, tensions have escalated over the 2016 detention in Turkey of American pastor Andrew Craig Brunson. He is accused of spying for the Kurdistan Workers’ Party and the Fethullah Terror Group, the name Turkish authorities have given to the movement inspired by Fethullah Gulen, the U.S.-based cleric who was once an ally of the Turkish president and is now accused of orchestrating the failed 2016 coup. The U.S. has insisted on Brunson’s release and even went as far as pressuring Israel to release a Turkish woman suspected of aiding Hamas to secure the pastor’s return, according to a recent report by Haaretz. The woman was freed, but Brunson remains under house arrest.

Brunson has become a pawn in the talks over whether the U.S. will extradite Gulen. Turkey says it has provided Washington with evidence to support its extradition request, but the issue is complicated by the fact that, in the U.S., the courts have jurisdiction over extradition cases, leaving the executive with little power over Gulen’s fate. Even if the Trump administration were to support Gulen’s extradition, a judge would have to rule on the case. The extradition treaty between the U.S. and Turkey states that extradition requests can be denied if they were made to prosecute or punish a person for “an offense of a political character or on account of his political opinions.”

On Wednesday, the U.S. announced that it would impose sanctions on two Turkish government officials over Brunson’s continued detention. Turkey has demanded that the sanctions be lifted and promised to respond in kind.

Common Interests

Turkey and the U.S. clearly have many issues pushing them apart, but they also have some common interests drawing them together.

The most important relates to Russia. Despite Turkey’s cooperation with Russia in the Syrian war – which became increasingly necessary as Turkey became more involved there and needed to avoid clashing with Syrian government troops backed by Russia – Ankara nevertheless remains wary of Moscow. The two have fought countless wars since the 18th century. Turkey was a key part of the containment line against the Soviet Union in the Cold War, and they nearly came into direct military conflict during the Nagorno-Karabakh War between Armenia and Azerbaijan in the early 1990s.

Historical competition between Russia and Turkey was driven by two factors. The first was Russia’s desire to seize control of the Bosporus from the Ottomans so that it could have guaranteed access to the Mediterranean. The second was Russia’s desire to drive out the Ottomans and Iranians in the South Caucasus. Ultimately, Russia wants to keep Turkey, as well as Iran, from establishing a strong presence in the South Caucasus, since any state with a foothold there can threaten Russian territory in the North Caucasus. Turkey has historical links to the Caucasus, particularly in Azerbaijan, whose population is dominated by a Turkic ethnic group. Turkey’s purchase of Russian weapons systems won’t change these realities, which have made them adversaries for centuries.

Disagreements over Syria

Both countries have also supported opposing sides in Syria. Bashar Assad has reconquered southern Syria, and the largest portion of the country that remains out of his grasp is Idlib province, which Turkey essentially controls (though militias are still present there) both directly and through its proxy, the Free Syria Army. There are roughly 40,000-100,000 FSA fighters in Idlib, a far larger force than Assad encountered in the south. And given the presence of the Turkish military, he will face a more formidable and relatively modern army with substantial air support in Idlib. Assad thus needs Russia’s air power, but it’s unlikely that the Russians would rush into a war with Turkey at this point – bombing jihadist militants is one thing, but starting a war with another nation-state is another. And Russia is more concerned with ending the Syrian war than starting a new one with Turkey.

It’s important, though, to remember why Russia backed Assad in the first place. Russia allied with the Syrian regime to oppose Western interests, just as the Soviets did during the Cold War. And this has brought it into conflict with Turkey and the United States. Though Russia does not pose the same expansionist threat to the U.S. as the Soviet Union did during the Cold War, it nevertheless continues to challenge American interests in the world. Russia does this both to limit America’s power in areas where Russia has vital interests (such as Ukraine and Georgia) and to build leverage in areas of peripheral importance that it can then use in negotiations on areas of central importance. The U.S. thus benefits from having Turkey as a regional ally that has a long-term interest in limiting Russian intervention in the Middle East.

The U.S. and Turkey have other interests in common. Washington needs Ankara as a non-Arab partner in the Middle East that can counterbalance Iran, which has supported the Assad regime in Syria, backs the Houthis in Yemen and has Hezbollah as its proxy in Lebanon. But limiting Russia’s reach is still the main reason they need each other. Therefore, the key indicator of the strength of U.S.-Turkish relations is the balance of power between Turkey and Russia. If Turkey grows stronger relative to Russia, Ankara’s need for U.S. support will diminish.

As the U.S. and Turkey squabble over issues such as American pastors, F-35 deliveries, and the finer points of the Syrian civil war.

The Lira

The Turkish lira has gone from steady decline to precipitous fall. It has declined roughly 40 percent since the beginning of the year and roughly 14 percent since the beginning of the day. Many have blamed this financial calamity on the Trump administration. After all, it has placed sanctions on a few Turkish officials, it has threatened to remove Turkey from a program that allows it to export some products to the U.S. duty-free, and just today, and it announced it would double steel and aluminum tariffs.

The U.S. is often a strawman for the poor performances of struggling economies. And to be sure, the measures Washington has imposed are not good for the Turkish economy. But Turkey’s economic problems are structural, and the lira has been declining since the beginning of the year. Washington’s moves against Turkey are punitive, but they aren’t the causes of Turkey’s economic problems. They are a consequence of them – namely, Turkey’s dependence on external debt, and therefore its dependence on foreign reserves. The U.S. sees in Turkey a weakness it can exploit.

Indeed, Turkey’s economic growth since 2002 has been fueled largely by external debt – that is, debt denominated in a foreign currency. Turkey’s low saving rate means that, despite high interest rates, there was not enough local capital in the Turkish financial system to provide enough loans to spur growth. So it borrowed from foreign countries. The problem with debt denominated in a foreign currency is that it becomes much harder to pay down when the currency in question weakens. Such is Turkey’s dilemma.

To hedge against the risk from external debt, Turkey built up its foreign reserves. But it did so in a novel way. The Turkish central bank’s reserve option mechanism permits Turkish banks to hold capital reserves in not just Turkish lira, but also foreign currencies (and gold). However, if banks substitute foreign currencies for the lira as their reserves, they must deposit that foreign currency at the central bank. This means that a substantial portion of the foreign reserves held at the central bank isn’t simply something the bank can buy or sell as it chooses. It also comprises a portion of the capital reserves of the Turkish banking system.

As the lira declined this year, the central bank reduced the reserve option mechanism’s foreign exchange ratio, meaning that it allows less foreign currency to be held as reserves at the central bank in substitution for lira reserves. In May, this figure was reduced from 55 percent to 45 percent, and earlier this week, it was reduced to 40 percent. This can basically be thought of as selling foreign reserves to boost the lira. Earlier this week, it seemed to work as the lira briefly gained strength. But since many of these headline foreign reserves are basically borrowed by the central bank from individual Turkish banks, the decline in this ratio also represents a general weakening of the Turkish banking system.

As the week went on, the lira continued to fall, proving that the reserve option mechanism is ineffective and thus removing one tool the government thought it had to maintain foreign reserves. (Turkey’s foreign reserves have fallen from $95 billion to $78 billion since the beginning of 2017.) To stem the decline of the lira, Ankara may have to make the politically unpopular decision to raise interest rates. President Recep Tayyip Erdogan has discouraged further increases for fear that it will reduce the availability of credit Turkey needs to grow.

Of course, none of these developments are purely economic. A poor economy affects Turkey’s military capabilities and its politics. A weak currency means that, as more money must be dedicated toward foreign debt service, less money will go toward more productive areas of the economy. Declining economic activity will impact tax revenue, which will in turn put pressure on Turkey’s military spending – hence Turkey’s growing urgency to develop a domestic defense industry that depends less on imports. If the economy becomes unduly weak and if Erdogan is not able to convince the country that its economic woes are solely America’s fault, then Turks may begin to question why the government is spending so much in Syria.

The president’s efforts in that regard will only aggravate tensions between the U.S. and Turkey – a curious strategy, considering the general frailty of the Turkish economy. The alliance between these sometimes-partners seems more tenuous every day.