Geopolitical “hot spots” could deepen economic and financial crises in the Mediterranean region, with Turkey and Egypt at risk of all-out war. The long-running conflict in Libya between the UN-backed, internationally recognized Government of National Accord and the Libyan National Army, led by a former Qaddafi general, is at risk of escalation. Turkey has long backed the former largely for access to Libya’s vast energy resources, and Egypt, along with Russia, supports the latter.

Egypt has been an investor favorite in recent months after 3 years of IMF-guided economic reforms including subsidy cuts. Unlike many EM peers, its credit rating has not been cut and the World Bank and private analysts expect the economy to grow this year. It accessed emergency and longer-term funding from the IMF and raised USD 5 billion in a massively oversubscribed Eurobond sale.  Local bonds yielding 8%+ along with a steady currency have attracted fresh foreign inflows, helping to keep foreign reserves healthy. However, parliament has approved the deployment of troops to Libya which would hike military spending, further pressuring the widening budget deficit already hit by Covid-related spending and a collapse in the critical tourism sector.  After leading the asset class rally, investor sentiment will sour on open military conflict.

Turkey is already at the edge of the cliff as net reserves sink to USD 32 billion, including gold and swap lines, despite official deposits from Libya. Two months of relative currency stability has reversed with inflation over 12%, sending the lira sharply lower even as authorities tighten control over the FX market leading to worry that capital controls could be imposed. Foreign investors have dumped local stocks and bonds as the economy contracts and real rates turned negative. Economic and financial market distress is compounded by rising tensions with the EU over migration and oil and gas rights in Mediterranean.  Adding war to the mix could easily tip Turkey into a full-blown balance of payments crisis.

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