ANALYSIS: US-Iran sanctions trial may hamper Turkey's struggling economy

A bad economic situation is quickly deteriorating for Turkey.

Already the country is suffering from high inflation, big trade deficits and a plummeting currency.

And now a US sanctions-busting trial has cast a spotlight on the alleged corruption and malfeasance of the government in Ankara, which will make the matter even worse, analysts say.

This case has the capacity to seriously damage relations between Turkey and the US

-TS Lombard

The publicity surrounding the case will likely lead investors to flee the Turkish lira and possibly send the country's currency down even further, said Marcus Chenevix, a Middle East, North African and global political research analyst at TS Lombard in London.

Amid the alleged connection of fired National Security Advisor General Michael Flynn to the case, observers can expect massive media attention.

Flynn was fired by President Donald Trump after a few weeks on the job. Flynn, who had been paid for lobbying work that "benefited the Republic of Turkey," pled guilty on Friday to lying to the FBI about a phone call he had with the Russian ambassador in the US.

The plea sent shock waves throughout Washington and dominated headlines across the country.

In other words, the sanctions trial will not pass unnoticed.

Still, the real problem for Turkey is the testimony of Turkish-Iranian businessman Reza Zarrab, who turned from being the defendant to being a witness.

Late in November, he implicated President Recep Tayyip Erdogan as being complicit in helping Turkey evade US sanctions on Iran.

The court story revolves around the state-owned Turkish Halk Bank, and Zarrab, a gold dealer who was accused of laundering money to the tune of hundreds of millions of dollars for the Iranian government in violation of US sanctions.

"This case has the capacity to seriously damage relations between Turkey and the US," said a recent report from TS Lombard. "From a US perspective, Turkey has been working to subvert American interests by secretly doing business with an enemy and is now insulting the American Judiciary and threatening American officials."

But Erdogan isn't taking the claims lightly. "Whatever the verdict is, we did the right thing," he said on Thursday.

Hot money

But the trial will have an impact on the Turkish economy, according to Chenevix.

"The testimony will likely raise questions about Turkey and cause hot money to leave, that's why it matters so much for the lira," Chenevix said.

Hot money is the description sometimes given to the cash used by currency speculators. In the case of Turkey's lira, the traders typically sell currencies where interest rates are low, such as the Japanese yen, and then buy higher-yielding currencies such as the lira. However, such trades are risky.

"Trading the lira is like picking up pennies on the side of a live volcano," Chenevix said. The pennies are plentiful, but you need to watch out for the occasional eruption and be prepared to flee, he explained.

The US court proceedings may provide the geopolitical eruption that will make the traders dump the lira in favour of safer currencies.

"An adverse court ruling could be very damaging to the currency," said Michael Woolfolk, a veteran currency strategist and financial consultant in New York City.

"There is the potential for a knee-jerk selloff in the lira."

Harsh markets

The trial would impact Turkey's financial markets in two ways: potential fines by the US banking sector and the market's parallel relationship to deteriorating relations between the US and Turkey.

Fines "would hurt profits and Turkey's stock market," William Jackson, a senior emerging markets economist at Capital Economics in London, said. That could get worse if it also means the banks can't borrow from abroad as they usually do, he added.

The other effect is if Turkey-US relations deteriorate, then the "markets have tended to react to any deterioration" in the relationship between the NATO allies, Jackson said.

Either way, the already struggling Turkish economy would be hurt, and the currency would take a further beating.

Recently $1 would fetch 3.9 lira, according to data from Bloomberg. A year ago, the greenback would get you 3.4 lira.

The impact on the lira has the potential to be swift, possibly pushing it past 4 lira to the US dollar, according the Lombard report.

That extra currency depreciation would exacerbate the country's inflation rate above the registered 11.9 percent from October, which is already up from less than 10 percent in July, according to data from the Trading Economics website.

Food inflation is even higher, at 12.74 percent in October, up from 10.01 percent in July. Food inflation is likely to get worse when the lira depreciates because a significant volume of food is imported from outside the country.

Inflation isn't the only problem. A weaker currency may widen an already-large trade gap, which is the dollar amount of how much imports exceed exports.

For October, the latest data available, the trade deficit totaled $7.32bn, down slightly from the month before but almost double the $3.7bn seen in February, again according to data from Trading Economics.

"The external accounts are deteriorating just as it is becoming harder to finance these deficits," said a recent report from financial firm Brown Brothers Harriman in New York.

Typically, trade deficits are funded by other countries’ lending money. Without enough lending, the currency may deteriorate further. "Reliance on hot money flows makes the lira even more vulnerable," the report added.

Jittery investors

Meanwhile, the economic and political malaise already has stock investors cutting back on their exposure to the country.

"With the TRL [Turkish lira] set to become the worst performing EM [emerging market] currency of 2017 amid increased inflationary pressures and lingering political tensions with the US, Turkey's weight in fund investors EM portfolio has slumped," a recent report from the Washington-based Institute of International Finance said.

Specifically, the share of money emerging market investors allocate to Turkey has fallen to 1.6 percent of a portfolio from an average of 2.3 percent for the last six or so years, according to the institute's report.

To cap it all off, bond investors aren't too happy either. Turkish government debt has been one of the worst-performing bonds of the year, according to a recent BBH report.

The government 10-year bond now yields more than 12 percent, up from around 11 percent at the beginning of the year, according to data from Trading Economics. The higher borrowing costs will eat into the government's budget.