By Caitlin Ostroff
The lira's sharp drop in recent days is fueling concerns of a fallout that could spread beyond Turkey's borders. Next up: the euro.
The lira has fallen almost 19% against the dollar this year, on pace for its steepest annual decline since 2018, when it lost more than a quarter of its value. Against the euro, it has lost a fifth of its value this year.
Turkey's central bank has tried to prop up its currency by depleting most of its own foreign-exchange reserves and selling billions of borrowed dollars to buy lira. But efforts have faltered in recent weeks. The currency has dropped 6.6% against the dollar since July 24, prompting speculation that the central bank is running low on options.
The renewed pressure on the currency is raising alarms about Turkey's long-term ability to repay its foreign debtors, which include European banks. A weaker lira also makes imports more expensive and threatens to curb Turkey's appetite for goods from Europe when the pandemic has already eroded trade and output from the trading bloc.
"If the situation continues to intensify in Turkey, that could have spillover effects on the euro," said Lee Hardman, a currency analyst at Japan's MUFG Bank. "The eurozone has tighter trading links with Turkey than the U.S."
Turkey isn't a member of the European Union, though it has a close trading relationship with the trading bloc. Last year, Turkey was its sixth-largest export market for merchandise.
European banks have reduced their exposure to Turkey since the country's 2018 currency crisis, as a weakening lira could leave Turkish companies and banks struggling to make interest payments or redeem their overseas debt. But Spanish and French banks continue to have the most loans outstanding to Turkeyof all non-Turkish lenders, according to the Bank for International Settlements, far outpacing U.S. banks.
Turkey has fueled demand for imports this year by lowering interest rates and expanding access to cheap credit for households and companies. That is particularly problematic because it comes as the country is earning less dollars and euros because of waning tourism and a slump in exports. The funding gap between imports and exports has widened, increasing the current-account deficit and exacerbating the need for foreign currencies.
The worsening economic picture has left investors speculating that the nation is edging closer to a balance-of-payments crisis. That would leave Turkey unable to pay for imports from Europe, or make payments on its external debt.
An embattled Turkish economy and reduced demand for European goods may pose a threat to the pace of the EU's recovery from the virus-induced recession, investors said. Speculation that the EU would rebound faster than the American economy, in part because it has appeared to curtail fresh outbreaks more effectively than the U.S., pushed the euro to a two-year high against the dollar at the end of July.
"Given that the euro has been front running that European growth story, you could see some of that narrative get priced out," said Viraj Patel, a foreign exchange and global rates strategist at research firm Arkera.
The euro slid 0.2% against the dollar Monday, limiting its advance this year to about 4.9%. The ICE U.S. Dollar Index, which measures the greenback against a basket of major currencies, gained 0.1% Monday. The dollar index has shed more than 3% this year.
In a sign of investors' diminishing risk appetite, the yield on the 10-year U.S. Treasury slid to 0.549%, from 0.562% Friday. Yields fall when bond prices rise.
Pat Minczeski contributed to this article.
Write to Caitlin Ostroff at caitlin.ostroff@wsj.com
