Turkey may be the spark that lights a fire in the world economy

The battle waged by Turkey's Recep Tayyip Erdogan against currency speculators is a classic pyrrhic victory. The show of resolve by the self-styled strongman on Wednesday stopped investors from dumping the lira but at enormous cost in both the short and long term. That Turkey will be damaged is beyond question. All that's in doubt is how severe that damage will be and whether the fallout will be felt elsewhere. Looking at the fragile state of the global economy, there's every chance it will be.

The backdrop to the latest instalment of a long-running crisis is that Erdogan is this week facing important local elections at a time when the Turkish economy is in recession. In an attempt to drum up support, Turkey's president last week condemned Donald Trump's decision to recognise Israeli control over the Golan heights, but this proved a spectacular own goal by convincing foreign investors that Ankara was on a collision course with Washington.

The lira plunged.

Erdogan’s response was to stop speculators heading for the exit by preventing foreign banks from getting access to the lira they needed to close out their positions. This halted the run on the currency but at some cost: borrowing costs soared, as did the cost of insuring Turkish debt against default. The stock market plunged by 6 per cent in its worst day for almost three years. The plan is to lift the restrictions once the weekend elections are over, but the damage is already done.

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Turkey relies on foreign investors to fund its large current account deficit so burning their fingers is not the smartest long-term strategy. Interest rates will stay higher for longer, deepening the recession and slowing the pace of recovery. A full-blown run on the lira cannot be ruled out.

The assumption in the financial markets is that Turkey is a one-off and that there will be no ripple effects. That, though, is what the markets always say. But the global economy is slowing, bond central banks have shelved plans to raise interest rates, investors are prepared to accept negative yields for the security of holding German bonds and the yield on a 10-year US bond is below that on a three-month bond – in the past a signal of a recession in the offing.

Sometimes it only takes a spark and Turkey could easily provide it. – Guardian service