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Turkey Special July 2019

Turkey: Tensions rise with the U.S. and EU; possibility of comprehensive sanctions looms

In recent weeks, geopolitical confrontation has dominated headlines due to Turkey’s decision to go ahead with its purchase of a Russian missile system and drilling activity off the coast of Cyprus. The missile purchase could lead to wide-ranging sanctions from the United States, while drilling activity has already led the EU to announce some retaliatory measures that could leave a mark on Turkey’s private sector. Rising tensions could rattle investor and business confidence, weaken economic activity and lead to further lira depreciation, rocking an already shaky economy that is only slowly getting back on its feet after last year’s currency crisis.

The first shipments of the Russian S-400 missile system arrived in Turkey in mid-July. Subsequently, U.S. President Donald Trump expelled Turkey from the F-35 fighter jet training program, while Turkish firms are set to be cut from the global supply chain of the F-35; Turkish manufacturers are set to lose contracts worth billions of dollars as a result. While these developments will have some impact on the Turkish economy—both directly and indirectly as relations between the U.S. and Turkey sour, shaking investor confidence—the U.S. could impose more comprehensive sanctions on Turkey through the Countering America’s Adversaries Through Sanctions Act (CAATSA). The CAATSA specifically targets entities that engage with the Russian defense industry. Moreover, sanctions on Turkey appear to enjoy bipartisan support in the United States. Thus, in the case that President Trump—who expressed sympathy for Turkey’s position in late June—decided not to make a move, Congress could override his decision.

Simultaneously, the European Union adopted disciplinary measures against Turkey over its drilling activity in waters off the coast of Cyprus. The measures that were approved in mid-July include a suspension of the EU-Turkey Association Council and dialogues; a reduction of the pre-accession financial assistance to Turkey next year; a review by the European Investment Bank of its lending activity in Turkey; and a suspension of negotiations on the Comprehensive Air Transport Agreement. The direct impact of these actions is expected to be limited due to the relatively small amount of funds involved; however, the indirect impact could be more costly for the Turkish economy through deteriorating investor sentiment. In particular, roughly half of all external loans held by Turkish banks and firms originate from European private creditors. If European creditors grow more skittish, this could limit Turkish corporates’ ability to borrow. Moreover, further EU sanctions are possible, although Turkey has a card up its sleeve in its dealings with the EU: the refugee deal limiting the influx of irregular Syrian immigrants entering the EU through Turkey. It is therefore likely the EU will seek a compromise.

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