Turkey's crisis highlights global risks

President Donald Trump's move to double metals tariffs on Turkey over its refusal to release Pastor Andrew Brunson has deepened the country's economic crisis and sent shockwaves around the world. Turkey's currency plumbed record lows before stabilizing somewhat, heightening concerns about its ability to pay off large debts to foreign creditors, as well as over the US's increasingly muscular use of sanctions. Here are some signposts to watch in the evolving crisis:

Interest rates. Investors were unnerved by the central bank's failure to raise interest rates in July despite spiraling inflation, raising questions about political influence over its decisions—President Recep Tayyip Erdogan has repeatedly argued in favor of low interest rates—and contributing to the lira's decline. In response to the deep currency swoon of recent days, the bank has taken small steps to boost liquidity in the financial system. But analysts say it needs to act forcefully with a hike in its key interest rate of up to 10 percentage points to bring an inflow of cash deposits and buoy confidence.

Erdogan rhetoric. Fresh from a June reelection victory that allowed him to assume expanded presidential powers, Erdogan has given every indication he plans to resist for as long as possible a rate hike that could restrain growth. He recently published an op-ed in the New York Times, warning the Trump administration not to continue pressing it on Brunson, and has made more defiant statements since then. But history suggests the strong-willed leader is capable of reversals when the stakes are high enough, such as when he backtracked on his initial strong rhetoric and apologized to President Vladimir Putin in 2016 for the downing of a Russian airplane.

White House escalation. Never one to back down from a fight, Trump tweeted his threat to raise tariffs on Turkish aluminum to 20% and steel to 50% just a few hours after the publication of Erdogan's op-ed, gleefully noting that the Turkish currency “slides very rapidly downward against our very strong Dollar!” The statement highlighted just how far the US has shifted from its traditional role as a custodian of stability in the world's dollar-centered financial system, and fueled concerns over the risks of  aggressively employing sanctions in political disputes. Still, it might not be easy to dissuade the Trump administration from taking further measures against Turkey; The aggressive defense of the jailed American pastor plays well with conservative Republican voters ahead of the November midterms and is not one Democrats are likely to criticize. Treasury Secretary Steven Mnuchin said the US is ready to take tougher steps if Turkey doesn't free Brunson.

Balance of payments crisis. As its currency comes under continued pressure, Turkey could be hurtling toward a crisis in which it wouldn't be able to pay back a massive pile of debt denominated in foreign currencies, estimated to stand at more than 50% of the country's GDP.  In order to avert bankruptcy, the country could be forced to seek a bailout from the International Monetary Fund, something that financially profligate national authorities are always eager to avoid because of the politically difficult conditions that come attached. For Erdogan, it would also force him to mend fences with the US, the IMF's largest shareholder.

Risks of contagion. Turkey's deepening crisis comes at a time when emerging markets around the world are under pressure from rising US interest rates that redirect capital flows to the world's largest economy and lead to an appreciation of the dollar, which makes it harder to pay off dollar-denominated debt. Turkey's problems triggered a sell-off earlier this week in the assets of Indonesia and South Africa, other markets that are heavily reliant on foreign investors. It has also put the spotlight on Turkey's trading partners and foreign creditors, many of which are located in the EU. In fact, Turkey is the fifth largest market for EU goods and services exports. Though the exposures of Spanish and French banks to Turkey are probably manageable for these large institutions, a broader emerging markets crisis would be more problematic.