As a recession settles in over Turkey following a currency crash last summer and a selloff in local markets, the stakes are getting higher. Turkey relied on foreign capital to finance its credit-fueled growth in 2016-2017, a period when portfolio inflows averaged $1.3 billion a month and the current account sank deeper into deficit. Investors fled Turkish assets last year, and outflows continued for eight months straight before stabilizing.
This week, Turkey further roiled markets by preventing foreign banks from accessing the liras they need to close out their swap positions. That’s made it almost impossible for bankers to short the lira or exit carry trades, and forced the overnight lira rate up to about 1,000 percent from 23 percent.
Some foreign banks were unable to meet their obligations at the close of trading on Tuesday, forcing the central bank to extend hours for transferring funds in Turkey to 9 p.m., according to a senior Turkish official, who spoke on condition of anonymity. On Wednesday, the Turkish stock and bond markets took the brunt of the hit from the measures meant to protect the lira: banking stocks were down more than 7 percent and the yield on 10-year lira bonds rose 74 basis points to 18.23 percent.
Turkey’s shocking intervention this week – which sought to punish speculators who were betting against the lira – is more confirmation that the country’s financial and economic situation is spiraling out of control. The primary reason for this turmoil is the bursting of Turkey’s 15 year old credit bubble (see my warning about this). To summarize, a credit bubble formed in Turkey starting in the early-2000s, which led to an artificial economic boom. Private sector credit grew from roughly 15% of GDP in 2003 to 70% of GDP in 2016. Surging interest rates are now bursting the credit bubble and putting an end to the artificial economic boom.
Unfortunately, Turkey’s situation is only going to get worse – a 15 year-old credit bubble doesn’t resolve in a mere six months. This week’s currency intervention will only serve to scare away foreign investors, which will contribute to the downward spiral. Turkey is just one of many emerging economies that have experienced credit bubbles in the past decade due to the stimulative actions of global central banks. Bubbles – including the one in Turkey – have caused global debt to explode by $150 trillion in 15 years and $70 trillion in 10 years. Even if you do not invest directly in Turkey, you are still likely exposed to contagion risk – welcome to the downside of globalization.
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What Turkey Can Teach Us About Gold
If you were contemplating an investment at the beginning of 2014, which of the two assets graphed below would you prefer to own?
Data Courtesy: Bloomberg
In the traditional and logical way of thinking about investing, the asset that appreciates more is usually the preferred choice.
However, the chart above depicts the same asset expressed in two different currencies. The orange line is gold priced in U.S. dollars and the teal line is gold priced in Turkish lira. The y-axis is the price of gold divided by 100.
Had you owned gold priced in U.S. dollar terms, your investment return since 2014 has been relatively flat. Conversely, had you bought gold using Turkish Lira in 2014, your investment has risen from 2,805 to 7,226 or 2.58x. The gain occurred as the value of the Turkish lira deteriorated from 2.33 to 6.04 relative to the U.S. dollar.
Although the optics suggest that the value of gold in Turkish Lira has risen sharply, the value of the Turkish Lira relative to the U.S. dollar has fallen by an equal amount. A position in gold acquired using lira yielded no more than an investment in gold using U.S. dollars.
Data Courtesy: Bloomberg
This real-world example is elusive but important. It helps quantify the effects of the recent economic chaos in Turkey. Turkey’s economic future remains uncertain, but the reality is that their currency has devalued as a result of large fiscal deficits and heavy borrowing used to make up the revenue shortfall. Inflation is not the cause of the problem; it is a symptom. The cause is the dramatic increase in the supply of lira designed to solve the poor fiscal condition.
A Turkish citizen who held savings in lira is much worse off today than even two months ago as the lira has fallen in value. She still has the same amount of savings, but the savings will buy far less today than only a few weeks ago. Her neighbor, who held gold instead of lira, has retained spending power and therefore wealth. This illustration highlights the ability of gold to convey clear comparisons of various countries’ circumstances. It also illustrates the damage that imprudent monetary policy can inflict and the importance of gold as insurance against those policies.
Using Turkey as an example also helps illustrate why we say that inflationary regimes impose a penalty on savers. Inflation encourages and even forces people to spend, invest or speculate to offset the effects of inflation. Investing and speculating entail risk, however, so in an inflationary regime one must assume risk or accept a decline in purchasing power.
Most people think of inflation as rising prices. Although that is the way most economists represent inflation, the truth is that inflation is actually your money losing value. Inflation is not caused by rising prices; rising prices are a symptom of inflation. The value of money declines as a result of increasing money supply provided by the stewards of monetary discipline, the Federal Reserve or some other global central bank.
This is difficult to conceptualize, so let’s bring it home in a simple example. If you live in a country where the annual inflation rate is a steady 2%, the value of the currency will decline every year by 2% on a compounded basis. At this rate, the purchasing power of the currency will be cut in half in less than 35 years.
Now consider a country, like Turkey, that has been running chronic deficits, printing money rapidly to make up a revenue shortfall, and begins to experience accelerating inflation. The annual inflation rate in Turkey is now estimated to be over 100% or 8.30% per month, a difficult number to comprehend. The value of their currency is currently falling at an accelerating pace so that what might have been purchased with 500 lira 9 months ago now requires 1,000 lira.
Put another way, for the prudent retiree who had 10,000 lira in cash stashed away nine months ago, the inflation-adjusted value of that money has now fallen to less than 5,000 lira. If inflation persists at that rate, the 10,000 will become less than 1,000 in 29 months.
Believe it or not, Turkey is, so far, a relatively mild example compared to hyperinflationary episodes previously seen in Germany, Czechoslovakia, Venezuela, and Zimbabwe. These instances devastated the currencies and the wealth of the affected citizens. Fiscal imprudence is a real phenomenon and one that eventually destroys the financial infrastructure of a country. For more on the insidious role that even low levels of inflation have on purchasing power, please read our article: The Fed’s Definition of Price Stability is Likely Different than Yours.
There are over 3,800 historical examples of paper currencies that no longer exist. Although some of these currencies, like the French franc or the Greek drachma disappeared as a result of being replaced by an alternative (euro), many disappeared as a result of government imprudence, debauching the currency and hyperinflation. In all of those cases, persistent budget deficits and printed money were common factors. This should sound worryingly familiar.
Modern day central banks function by employing a steady dose of propaganda arguing against the risks of deflation and in favor of the benefits of a “modest” level of inflation. The Fed’s Congressional mandate is to “foster economic conditions that promote stable prices and maximum sustainable employment” but promoting stable prices evolved into a 2% inflation target. The math is not complex but it is difficult to grasp. Any number, no matter how small, compounded over a long enough time frame eventually takes on a parabolic, hockey stick, shape. The purpose of the inflation target is clearly intended to encourage borrowing, spending and speculating as the value of the currency gradually erodes but at an ever-accelerating pace. Those not participating in such acts will get left behind.
In the same way that rising prices are a symptom of inflation attributable to too much printed money in the system, deflation is falling prices due to unfinanceable inventories and merchandise pushed on to the market caused by too much debt. Contrary to popular economic opinion, deflation is not falling prices caused by a technology-enhanced decline in the costs of production – that is more properly labeled as “progress.” The Fed is either knowingly or unknowingly conflating these two separate and very different issues under the deflation label as support for their “inflation target”. In doing so, they are creating the conditions for deflation as debt burdens mount.
Gold, for all its imperfections, offers a time-tested, stable base against which to measure the value of fiat currencies. Accountability cannot be denied. Despite the unwillingness of most central bankers to acknowledge gold’s relevance, the currencies of nations will remain beholden to the “barbarous relic”, especially as governments continue to prove feckless in their application of fiscal and monetary discipline.
‘Dr. Copper’ Plunges In Worrisome Sign For The Global Economy
As if the recent turmoil in Turkey, South Africa, and other emerging markets wasn’t enough, commodities including copper are now sinking as well. Copper, which is known as “the metal with a PhD in economics” due to its historic tendency to lead the global economy, is down nearly 4 percent today alone and 22 percent since early-June. Copper’s bear market of the past couple months is worrisome because it signals that a global economic slowdown is likely ahead.
The chart below shows how copper was bouncing around in a range between $3 and $3.3 per pound until it peaked and broke down in June:
The longer-term chart shows how copper surged after Donald Trump’s election win (due to expectations of an infrastructure boom), climbed within a channel pattern, and then broke down from the channel in late-2017. The $2 per pound support is the next major level to watch if copper’s bearish trend continues.
Copper and other base metals are falling for a wide variety of reasons including the plunge in Turkey and other emerging markets, the strengthening U.S. dollar, and China’s economic slowdown due to the trade war. If the dollar continues to rise and the emerging markets turmoil spreads (which I ultimately expect to happen), there is a high likelihood that copper will continue its downward trend.
Why Turkey’s Bubble Economy Is About To Pop
Though Turkey’s financial markets have been struggling since the start of this year, the country’s currency and government bonds have been in an all-out freefall in the past week. A political clash with the United States caused the lira to lose approximately one-third of its value against the U.S. dollar in the last week alone. In an attempt to stem the lira’s plunge this year, Turkey’s central bank has hiked interest rates quite dramatically, which is a move that earned approval from many mainstream economists and analysts. Unfortunately, I believe that Turkey’s aggressive recent interest rates hikes are going to pop the country’s dangerous credit bubble that I warned about in Forbes in 2014.
The chart below shows the Turkish lira’s recent plunge against the U.S. dollar:
As I explained in my original bubble warning, Turkey has been experiencing a powerful economic boom since the early-2000s thanks to ultra-low interest rates and the resultant rapid credit growth. The chart below shows how Turkey’s benchmark interest rate kept falling from the early-2000s until the mid-2010s. Extremely loose global monetary conditions after the Global Financial Crisis led to a “tsunami of liquidity” that flowed into emerging economies such as Turkey, which caused interest rates to fall well below normal historic levels. Now that the U.S. and other countries have been ending their QE programs and raising interest rates, emerging market currencies and bonds have been taking it on the chin.
The chart below shows Turkish 10-year government bond yields, which have surged recently:
Unusually low interest rates have encouraged a credit boom in which loans to the private sector have sextupled since 2010:
Consumer credit has increased fivefold since 2010:
The chart below shows domestic credit to the private sector as a percentage of GDP, which also confirms that a credit boom/bubble has been brewing in Turkey since the early-2000s:
Low interest rates have also led to a housing boom/bubble in which housing prices have increased by 172 percent since 2010:
Turkey’s economy has become reliant on cheap credit, and the recent interest rate hikes mean that the country’s cheap credit era has come to an end. Higher interest rates are going to cause a credit bust in Turkey, leading to a serious economic crisis. While most commentators believe that Turkey’s current turmoil is the result of U.S. sanctions, the reality is that the country’s crisis was already “baked into the cake” years ago. The recent political clash with the U.S. is simply the catalyst for the coming Turkish economic crisis, but it is not the actual cause. I am also highly concerned that Turkey’s current turmoil will lead to further contagion in emerging markets, which have also similarly thrived due to ultra-loose global monetary conditions that are now coming to an end.
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