The Turkish Lira is plummeting, and financial markets around the world are taking note – so what is going on?

At the start of August, US president Donald Trump imposed financial sanctions against two top Turkish government officials. It was an extraordinary move, as Turkish president Erdogan, and US president Trump were fist-bumping at a NATO summit meeting just days before, Trump even saying of Erdogan “I like him, I like him.”

The souring of relations between the two NATO allies (and indeed, their strong-willed leaders) is notionally over Turkey jailing American paster Andrew Brunson, who was arrested for espionage as part of a crackdown following a supposed coup attempt in 2016.

It appeared to be little more than a political spat between two tentative allies.

However, immediately after the sanctions were announced, we saw one of the largest currency moves of the past decade – with the Turkish Lira falling almost 40 percent against the US dollar in the two weeks since.

Dig a little deeper and it seems like the sanctions were simply a catalyst for financial issues that were already there. The Turkish financial system is currently experiencing run-away inflation and incredibly high foreign debt levels, and this is threatening to boil over into a full-blow crisis.

Most traders and investors agree that Turkey needs higher interest rates (some arguing for as much as a 1000 basis-point or 10% interest rate increase) to combat run-away inflation and stabilise the plummeting currency. Turkey is currently experiencing inflation of 16 percent, which is five times higher than the average of wealthy nations.

Lifting Turkey’s benchmark interest rates would be a start towards combatting a potential crisis, but most believe that pressure from President Erdogan means that this is unlikely to happen any time soon.

“Policy making is too top-heavy and run by Erdogan, and he simply has no idea how markets work,” according to Win Thin, a strategist at Brown Brothers Harriman in New York, who added that “the pastor is a sideshow”.

Erdogan has previously described interest rates as “the mother and father of all evil” and recently appointed his son-in-law to run the Turkish Central Bank.

Given Turkey’s high foreign debt levels and plummeting currency, financial markets are concerned about Turkish borrowers’ ability to pay back foreign-currency loans, which make up about 40 percent of the Turkish banking sector’s assets.

There are fears that if defaults start to rise, the effects could be severe for some of Europe’s struggling economies. Spain, French, and Italian lenders are owed $US83 Bn, $38Bn, and $17Bn by Turkish borrowers respectively.

In speeches over the weekend, Erdogan remained defiant. Stating that the country was in an “economic war”, threatening the US that Turkey would “start looking for new friends and allies”. Trump, for his part, tweeted “relations with Turkey are not good at this time”.

Regardless, even if the US acquiesce and remove sanctions, Turkey’s economic problems are likely to persist.