Despite extremely high inflation and unorthodox monetary policies, Turkey has so far avoided a systemic financial crisis. But its government's continued focus on near-term economic growth over long-term sustainability will increase the risk of the country entering such a crisis in 2023. Turkey's economy grew quickly in 2022 as the country emerged strongly from the COVID-19 pandemic and absorbed the initial shocks of Russia's war in Ukraine. But this brought with it soaring inflation (which hit an eyewatering 84% last month) and a deeply weakened currency (which has lost almost one-third of its value year-on-year). Unlike other countries that have responded to the post-COVID-19 and Ukraine-related surge in global commodity prices by tightening their monetary policies, Turkey has pursued monetary easing — resorting to orthodox and unorthodox measures to slow the lira's depreciation, which has increased the financial burden of companies with foreign-currency debt. But while this unconventional strategy has helped the Turkish economy expand at a time when most countries are facing a recession, it has also increased the country's exposure to a financial crisis, with market-based indicators of default risk increasing tangibly over the past year. 

• Turkey's economy expanded by 3.9% in the third quarter of this year, down from 7.6% in the previous quarter. 
• Inflation in Turkey reached 84% year-on-year in November (down slightly from 85% in October), compared with less than 20% a year ago. To mitigate rising consumer prices, the International Monetary Fund urged Turkey to raise interest rates in November. But the country's central bank has continued to lower its main policy rate, which has fallen to 9% from 16% over the past year. 
• The lira has depreciated 36% year-on-year despite significant efforts by the Turkish government to stem the decline through foreign-exchange sales and a variety of non-market measures.
• The spreads on Turkish credit default swaps, which insure investors against the risk of a sovereign default, are trading by more than 500 basis points — indicating a sizeable, if manageable, sovereign default risk. The three major international rating agencies — Standard & Poor's, Moody's and Fitch — have also all assigned a B rating to Turkey's credit, further signaling heightened financial risks.

Turkey's political establishment is coalescing around promoting rapid growth to bolster support ahead of the 2023 election, making it likely that Ankara's unorthodox economic policies will continue and may even accelerate in the coming year and potentially longer. Turkish President Recep Tayyip Erdogan is known for shunning the use of interest rates as a tool to fight inflation, driven by his personal religious beliefs that see interest as usury, as well as his general dislike of becoming overly dependent on Western-dominated financial institutions like the IMF. This ideology — coupled with his ruling Justice and Development Party (AKP)'s reputation for fueling economic growth in the early 2000s when it came to power — is what's driving Ankara's unorthodox economic strategy, which Erdogan has vowed to maintain through the upcoming June 2023 national elections. Moreover, the AKP's sagging approval ratings have begun to improve in recent months, suggesting that ordinary Turks' are on board with the party's current economic approach, which will further compel the ruling party to stay the course. But the AKP's primary rival, the opposition Republican People's Party (CHP), has also promised to continue expansionary policies, rather than impose politically unpopular austerity measures to curb inflation. This indicates Ankara's unorthodox policies are likely to continue in the months leading up to and directly after the 2023 election, regardless of who wins the vote. 

• Erdogan has said he would continue to favor lower interest rates, while the CHP has said it would favor increasing wages, especially for pension holders, to keep up with the rising cost of living. 

But this domestic policy focus on maintaining high growth regardless of underlying fundamentals, combined with the global economic slowdown, is increasing the risk of financial instability in Turkey. External liquidity — which is roughly the ratio of a government's foreign currency reserves to its levels of short-term external debt — is the single greatest risk to economic and financial stability in Turkey. Due to its expansionary monetary policies and higher energy-related import prices, Turkey's current account deficit will be much larger this year compared with last year, putting significant pressure on the lira's exchange rate. This has also left its central bank's net foreign exchange holdings in the red, sharply limiting the bank's ability to prevent further currency depreciation and provide support in case of balance-of-payments pressures. Non-financial corporates have large debts and their foreign-currency debt is only partially-hedged. Bank foreign exchange liabilities are in principle largely hedged, but regulatory forbearance and a lack of transparency make it difficult to assess the level of risk. The same applies to state-owned companies and state-owned banks. On the flip side, Turkey's corporate sector as a whole has built a small short-term foreign-currency creditor position, and government debt is at manageable levels. But this does not include future contingent liabilities related to COVID-19 relief measures and off-budget operations.

• The IMF has assessed that Turkey likely has insufficient external liquidity buffers, meaning it is at increased risk of external financial instability. Among other major emerging markets, only Argentina and South Africa have similarly poor metrics.
• The Turkish central bank's foreign currency reserves have fallen sharply in gross terms, and are now negative once liabilities are accounted for. A large amount of domestic foreign currency deposits (i.e. the liability of banks), along with the high share of liquid foreign currency assets held at the central bank, has left the balance sheets of both state-owned and private banks in Turkey vulnerable to shocks in the foreign exchange market. 
• Last year, Turkey's domestic foreign currency deposits amounted to $230 billion, while the reserves-to-deposit ratio was very low. 
• Turkey's corporate sector may see increasing defaults in the coming years. Corporate debt in Turkey as a share of total equity has risen sharply over the last decade, from 150% to 250% — translating into increased financial vulnerability. The country's manufacturing, trade, and construction sectors are especially poorly hedged with respect to export revenues, according to the IMF. 
• Like many other countries, Turkey has been hit by high energy and food prices, which have also fuelled inflation. Turkey is a major net energy importer, and more than 90% of its oil and gas consumption relies on imports, particularly from Russia. The current account deficit is set to reach 6% of GDP this year, increasing external liquidity — particularly against the backdrop of declining financial inflows.

Turkey could enter a greater financial crisis if global macroeconomic conditions further weaken or the government's current policy mix triggers systemic instability. Turkey may impose capital controls in the coming months to shore up the weakening lira — either directly, or by strengthening so-called ''backdoor'' controls that make it difficult for depositors to withdraw foreign currency. Ankara might take dollar deposits and utilize them to pay for deficits. The government remains unlikely to limit Turkish citizens from depositing foreign cash into their bank accounts, which would risk triggering political backlash and increasing dollarization at a household level. Abroad, Turkey might lobby the United Arab Emirates and Saudi Arabia to further invest in the country and potentially make direct deposits into Turkish banks to bolster the lira. These tactics will temporarily enable Ankara to keep cutting interest rates and boosting government spending. But such continued expansionary policies are steadily increasing the country's risk of entering a balance-of-payments crisis and ultimately a recession. This risk would be especially pronounced if Turkey's key trade markets like Europe enter a recession deep enough to impact exports substantially, and/or if foreign policy changes in Abu Dhabi or Riyadh prompt the wealthy Arab Gulf states to draw back their investments and currency support for Ankara. 

• Turkey's push to improve its ties with former regional rivals like Saudi Arabia and the United Arab Emirates is attracting more investments into the country that are, in turn, helping create more jobs for Turks. Saudi Arabia is reportedly preparing to deposit $5 billion into the country's central bank, while the United Arab Emirates has promised to invest $10 billion into the country. In August, the Abu Dhabi-based International Holding Co. also purchased a 50% stake in the Turkish renewable energy company Kalyon Enerji.
• According to analyses published by Bloomberg and the Financial Times in September, unexplained capital inflows from foreign sources are also currently helping cushion the country's widening account deficit. The mysterious sources of this cash are potentially unsustainable and likely hinge on Turkey maintaining positive political relationships with foreign partners, which means if these relationships change, Turkey could lose one of its current sources of foreign currency.

The Turkish government may return to more conventional and moderate economic policies after next year's election. But the risk of a recession will remain, as improving the country's long-term economic health will come at the cost of its recent growth. The AKP and the opposition are currently aligned in trying to buoy the economy as much as possible before next year's polls. But once polls close, there will be less immediate pressure to avoid unpopular austerity measures or interest rate hikes. This could shift Turkish leaders' calculus after the election by giving them more political breathing room to focus on policies that ensure the country's long-term economic sustainability. Within this context, Turkey's central bank may begin tightening its monetary policy to more quickly reverse inflation — especially if the opposition CHP (which backs a more orthodox central bank strategy) performs strongly in next year's polls. In addition, the Turkish government could scale back some of the expensive relief measures it's implemented to offset the negative social impact of high inflation, which would leave more foreign currency in Turkey's coffers and ease the risk of further crises in the future. But while such spending cuts and interest rate hikes would improve the country's long-term financial stability, they could also allow a recession to creep in by dampening Turkey's economic growth in the short term.