The crisis in Turkey is being caused by the US Fed, and we are only at the beginning
- The US Fed is unwinding its balance sheet, driving up the price of the dollar.
- This is the underlying cause of the Turkish lira crisis.
- Lots of countries, like Turkey, have external debt denominated in US dollars.
- The higher the dollar goes, the more expensive this debt becomes, and the closer we get to "contagion" in the shakier emerging markets.
- The Fed has only just begun.
The chart above shows the value of everything on the US Federal Reserve's balance sheet since the 2008 crisis. This, basically, is how the Fed rescued the global economy: It bought $4.8 trillion in bonds and other assets. Those purchases showered the planet with $4.8 trillion in cash. Some of it probably went into your paycheck.
It was rescue money, basically.
That little dip in the line this year, right near the end? That's the Fed beginning its long reversal. The global economy is now growing nicely. It does not need to be rescued. So it is starting to sell those assets, taking all that cash back.
America is not alone. The European Central Bank is tapering off the increases in its balance sheet, too. After September, there will be no more new rescue euros. In Britain, the Bank of England has started increasing its interest rate - another way of gathering in cash. The rescue sterling are going back into the vault, too.
The rescue money is saying bye-bye
That little dip doesn't look like much. But it represents a coming reduction of $600 billion annually, according to Russ Mould, AJ Bell's Investment Director.
Here is a closeup of the Fed's balance sheet from 2015 through to today:
Ah. That looks a lot more dramatic, doesn't it?
Now you can see why it is causing so much trouble in the global currency markets.
The narrative around Turkey and the crash of the lira is that this is a dispute between US President Donald Trump and Turkish President Recep Tayyip Erdoğan, over steel and aluminum sanctions, and whether the Turks should give up an America preacher they are holding under house arrest.
But neither of those issues is big enough to wipe 40% off the value of the lira.
The backdrop - the real driver - is the Fed's balance sheet.
As the Fed takes in dollars, it reduces the supply of those dollars globally. The value of each dollar goes up as the supply declines. A relative appreciation in dollars is the same as a relative depreciation for everyone else. That is what you see on this chart from Finviz, below. In dollar terms, most other currencies are taking a big hit:
Turkey has suffered more than everyone else - a 40% collapse in the lira - because its economy was built on high levels of deficit spending and "external" debt. That works when times are good. If your own currency is gaining in value, then it becomes easier over time to pay off debts in foreign currencies. And it tempts you to take on more of this ever-cheaper debt. You can keep an economy roaring along with that stuff.
And Turkey was roaring - 7% GDP growth (compared to 2 or 3% in the US and UK). But while the Turks were enjoying their economic miracle, their gross external debt reached $466 billion, about 60% of GDP, according to Bank of America Merril Lynch analyst Ferhan Salman.
The global tide of cash is receding
With the global tide of cash receding, and the scarcer dollar going up, it is now much more difficult for Turkey to obtain the money it needs to pay its debts and finance its government spending. The cost of Turkey's dollar-denominated debt is going through the roof as the lira plunges:
This is the tipping point
This is why you're hearing a lot of about "contagion" in emerging markets (small foreign countries, basically) and currency crises. This is why the Australian dollar is taking so many hits: The country does a lot of trade with China, Asia, and all those other Pacific nations. The Australian economy is a train. There has not been a recession Down Under in twenty-six years. But it's using the wrong dollar, so its currency now looks like this:
This is how recessions start
Economies that are doing just fine suddenly discover that their currency is no longer valuable enough to pay their bills. Recessions start like this. If one country can't pay its debts, people start pulling out of other countries like them.
This chart from Deutsche Bank shows you the global effect of that "little dip" we talked about earlier:
You'll notice that Turkey is actually the second country to be derailed by the strong dollar. Argentina has been grappling with a currency crisis all year.
Who's next?
Russia and Brazil are on the weak end of that chart, and they are major economies. The last time something like this happened was the Russian financial crisis of 1998, in which the entire country defaulted on its debt. Adding those two to the "crisis" list would be serious.
It is not yet clear that we're going to see a repeat of the emerging markets crises of the late 1990s. These things are not guaranteed. Perhaps, this time, it will be different.
But look again at that first chart of the Fed's balance sheet. The reason this is a truly scary moment in economics is that we've already got Argentina and Turkey scrambling, and the Fed has only just begun. There is a long, long way to go.
More on the Turkish lira crisis:
- UBS: Turkey could be heading into a balance-of-payments crisis
- The reason Turkey's economic collapse is so scary is that Iran, Russia, and Syria are waiting in the wings
- The lira's crash 'looks certain to push the Turkish economy into recession and may well trigger a banking crisis'
- Turkey's lira crisis may be down to Erdogan's fundamental misunderstanding of how 'evil' interest rates work