Turkey's deteriorating finances are hurting the country's banks whose reliance on dollar funding makes them vulnerable to the worst-case scenario: a sudden halt or reversal of foreign investment flows.
International investors are growing nervous about Turkey for a variety of reasons. But U.S. legal action against a number of Turkish individuals over alleged Iran sanctions busting – and the risk that some of the country's banks might be sucked into the case - lies at the heart of the latest concerns.
Since Turkey's financial crisis in 2000, its banks have earned a reputation as being among the best-run in emerging markets, holding capital reserves far above those required by global rules.
They are still borrowing funds on international markets for lending on to domestic clients, and executives say they do not expect any significant future difficulties.
Nevertheless, borrowing costs are rising for the banks, which have accumulated dollar debt piles equal to a third of Turkey's total foreign debt. Bank shares are down 20 percent since mid-August, outstripping a 5 percent fall on the broader Istanbul index in this period.
The lira has fallen more than 10 percent against the dollar and euro in the past three months alone, clocking losses of over 50 percent since the end of 2012 .
Several factors are at work, including fears that Turkey's credit rating might be downgraded, government resistance to higher interest rates despite double-digit inflation, and tensions between Ankara and NATO ally Washington.
Now a Turkish-Iranian gold trader on trial in New York has pleaded guilty to conspiring to evade U.S. sanctions against Iran and will testify against a Turkish bank official charged with arranging illegal transactions involving American lenders.
Any possibility that Turkish banks themselves might become involved, landing the kind of huge fines slapped on others for sanctions-busting, would have severe consequences for the lenders and the wider economy.
"If [fines] do materialize, I would assume that all lending would stop until it becomes clear if institutions around the world can lend to Turkish banks or not," said Alaa Bushehri, an emerging debt portfolio manager at BNP Paribas Asset Management.
Turkey's bank regulator and government officials have denied reports in Haberturk newspaper that six unnamed Turkish banks could face fines worth billions of dollars.
But Turkish banks' dollar bonds generally reflect investors' nervousness, Bushehri said. On average, yields are 100 basis points above sovereign debt, whereas most big Turkish non-bank firms have lower funding costs than the government, she noted.
Turkish banks also trade with higher yields than similarly-or worse-rated banks in Russia, an emerging market peer which is directly subject to Western sanctions.
U.S. prosecutors have charged nine people in the case, including the deputy general manager of Turkey's Halkbank, who is also on trial in New York. He denies all charges.
A former Turkish economy minister is among the defendants, although he is not currently on trial and likewise denies all charges. Ankara says the case is politically motivated, while Halkbank has said all of its transactions have fully complied with national and international regulations.
"If the trial were to end with fines on Turkish lenders, economic implications for Turkey could be highly adverse," TD Securities said in a note to clients.
Inflation hit a 9-year high of 11.9 percent in October, while Turkish bond yields have reached record levels above 13 percent. Ratings agency Standard & Poor's said on Wednesday an insufficient response by the central bank would be an immediate concern for Turkey's sovereign debt rating.
Deputy Prime Minister Mehmet Simsek has promised the government will do whatever is necessary if its banks are hit by the U.S. trial but Mehmet Emin Ozcan, CEO of state-owned Vakifbank, expects no negative impact.
"We didn't face any problem with borrowing from international markets and I don't think we'll have a problem in the future," he said this week.
Still, investors' fears persist. While international sanctions on Iran were eased last year, U.S. measures remain and penalties for any infringements can be devastating - as a $9 billion fine on French bank BNP Paribas last year attests.
The potential damage of any fines on Turkish bank reserves has exaggerated the lira's weakness, compounding the problems of the banks which have about $172 billion in external debt, according to Fitch ratings agency. Of this, $96 billion is due within the next year, the data showed at the end of September.
Health and growth
The issue is central to Turkey's economic health and growth.
As in other countries with low domestic savings, it relies on foreign borrowing, with banks acting as the conduit for a major part of the flows. Any stop in the financing could wreak havoc.
Turkish banks have average capital ratios that are double the 8 percent minimum stipulated by Basel 3 global banking rules. Also, the lira's depreciation should not compromise their ability to repay dollar debt as the regulator does not permit lenders to hold open, or unhedged, hard currency liabilities.
Fitch reckons banks can, if needed, access up to $90 billion over 12 months by tapping reserves they hold at the central bank and by unwinding currency derivatives positions. But a prolonged funding crunch will be a different story.
That would risk "pressures on foreign currency reserves, the exchange rate, interest rates and economic growth", Fitch warns.
That's because the lenders' capital buffers held with the central bank - totaling just over $60 billion - are a major part of authorities' $117 billion reserve war chest, and any depletion of this would leave the lira dangerously exposed.
"Usable" reserves - excluding gold and bank reserves – are around $35 billion, analysts estimate. That means the central bank will have no option but to raise interest rates sharply to counter any lira selloff, with damaging consequences for economic growth.
So far, the banks have avoided refinancing stress; Turkish lending is lucrative for European banks which may be unwilling to risk those long-standing ties.
Indeed, external debt rose around $9 billion in the first half of 2017, Fitch data showed, while Garanti Bank last week announced a $1.35 billion syndicated loan, with 38 banks participating.
But costs are rising - Garanti paid 1.25 percent above LIBOR on a one-year loan, while in 2016 and 2015 it paid 1.10 percent and 0.75 percent above LIBOR respectively.
Huseyin Aydin, chairman of the Banks Association of Turkey, told Reuters he had not observed any low appetite for taking Turkish risk. However, he added: "Foreign borrowing interest rates increased around 50-60 basis points in a tough year like 2017. It is possible that a limited increase will continue in
rates in 2018."
Paul McNamara, investment director at GAM, has been among those who have warned for some time of trouble. He said he has sold all his Turkish debt because of the banks' vulnerability.
"Local banks have borrowed an immense amount - north of $100 billion - abroad and lent that money on locally," he said. "Any stress on Turkish bank syndications and this goes bad very fast."