In a recent article by Business Insider Australia, the author profiled the country of Turkey, and the effect that it’s recent currency issues have had on the its national debt.
We have to understand an important concept when we talk about sovereign debt, or national debt. We talked about sovereign debt earlier.
There are two kinds of debt a country can take out:
- First, internal debt, or debt issued in its own currency. If Turkey wanted to raise Turkish Liras for example, and they did not want to simply print money (that would increase the supply of Liras and potentially cause inflation), they would instead sell debt at a certain interest rate. Turkish people would then buy the debt as bonds, and give the government cash in exchange for monthly interest payments.
- Or, there is external debt. External debt is when a country like Turkey borrows money from other countries, or from foreign banks. Those banks give Turkey foreign currency, Euros, for example, or US Dollars. Those banks would then require that Turkey pay them back in Euros and US Dollars, on a monthly basis at a certain interest.
The question then is, why would Turkey want to borrow money denominated in a foreign currency?
Well, one reason is that they want to make investments outside of Turkey. For example, if Turkey wanted to invest in the Japanese stock markets, they would need Japanese Yen. If the Turkish Pension Fund wanted to invest in the US Stock Market, they would have to find get US Dollars. The next question becomes, why borrow the money? Why not just exchange Liras for Euros, Yen, or Dollars?
We can answer that question very simply. The Turkish government would be shooting itself in the foot if it sold Liras and bought US Dollars. The act of selling Liras could be mistaken by the world currency market as the Turkish government disliking its own currency. This would cause others to sell also. The selling could be potentially contagious, which would be bad. Borrowing directly in foreign currency bypasses the foreign exchange markets.
Central Banks all over the world are involved on a daily basis in currency trading. They buy and sell their, and other, currency in order to keep the exchange rate for their own currency in a certain target range. Central Banks also conduct currency trading based on need; we won’t get into that here, but here’s a great article you can read if interested.
China’s Central bank, for example, has been forced to do quite a bit of FX trading, as its currency, the Yuan, has been battered by the Trump Trade Tariffs. Recently, the Chinese Central Bank has been buying Yuan and selling off US Dollars in order to support the value of its currency.
In a normal, tariff free environment, there is huge demand for Yuan from US companies since so many of them do business in China. This keeps the value of the Yuan strong and stable for Chinese citizens. In the pre-trade war environment, the trade imbalance between the US and China meant that China was left over with a lot of US Dollars. Instead of converting those back to Yuan, it buys US Treasuries with those Dollars. The effect is to prevent the Yuan from going too high? Why does China not want the Yuan to go too high? Because that would make Chinese products more expensive in the export market, specifically the US. In order for Chinese exports to be cheap, the Yuan must not be too expensive against the US Dollar.
This is one of the grievances Trump has with China; he wants them to stop capping the price of the Yuan. Why? Because Trump wants the Yuan to be more expensive, so that the US Dollar is cheaper. A cheaper US Dollar means US exports become cheaper. This would spur manufacturing in the US, create jobs, and win Trump votes.
From a currency perspective, the tariffs have worked against Trump. The Yuan has dropped in value because Chinese products became more expensive to export; but that drop in value has actually zeroed out the effect of the tariffs on the export market. This is why so far, the trade war has not had much of an effect on inflation in the US. American consumers have not seen a rise in prices yet; it still makes sense to buy Chinese, despite the tariffs.
The only side-effect for China is domestic inflation; that is why the Chinese Central Bank has gone from keeping US Dollars in receive, to selling some of of their massive US Dollar reserves, and buying Yuan, to keep domestic inflation from getting out of control. So far, it’s doing a good job.
Turkey does not have the same luxury as China. They do not have foreign currency reserves on par with China. We can get an idea for how much foreign currency reserves a country has by looking how many US Dollars a country owns. Why US Dollars? Because the US Dollar is the world’s reserve currency. It is essentially as safe as Gold. This is why an investment in the US Treasury debt (denominated in US Dollars) is a risk-free investment.
Turkey is nowhere to be found as a holder of US Treasuries in the above TIC data. That means their holdings of US treasuries are most likely small.
Possibly also likely is that they have a negative balance of US dollars, meaning they owe dollars to foreigners. This is exactly the case. If it were not for its foreign currency debt, Turkey would not be in crisis. Why? Because in the worst possible scenario, if it had massive amounts of domestic, Lira debt, Turkey could simply print Liras to inflate its way out of debt.
What does that mean? Inflating your way out of debt means you print money to cause inflation. This causes the price of everything, from labor, to rent and food, to rise. Inflation means without raising taxes, a country can raise its income, since more Liras will be paid on the present value of goods and services. Historical debt, debt issued before inflation, becomes much easily paid off.
What’s the catch? The catch is that anyone who owned debt suddenly is making less money in interest payments, in real terms (factoring in inflation). If they were collecting 5 Lira a month prior to inflation, they are still collecting 5 Lira a month when inflation hits, but that 5 Lira suddenly doesn’t buy as much. So the losers are the debt holders. Because debt holders tend to be banks, pension funds, companies, etc… purposely causing inflation doesn’t go over well with corporations and the wealthy. In addition, governments that purposely cause inflation lose the trust of investors. Argentina is a good case of that. Today, Argentina has a hard time getting loans from anyone outside of the IMF (International Monetary Fund); private investors have all but fled.
This is why it’s rarely done. This is why countries like Turkey look for alternative ways to raise money, on the international markets.
So the question is then, why did foreign banks agree to borrow money to Turkey? The reason is because foreign currency has been super cheap for a long time, ever since the 2008 crisis. The US Dollar, the world’s benchmark, reserve currency, was being offered to the world for 0.25% interest. Large international banks would go to the US Federal Reserve, borrow money at 0% (actually, what they did is they sold their US Treasury holdings in exchange for US Dollars aka quantitative easing) and then searched out ways to make a profit.
When the risk-free rate, which is the rate on US Dollar short term investments, is so close to 0%, investors find it very difficult to make safe investments. They take more risk, because it’s the only thing that yields any interest. In an environment where the risk-free rate is 3-4%, no one would ever borrow money to Turkey in foreign currency. But when it’s 0.25%, they are forced to lower their standards, all in the name of yield.
Lets compare the two graphs below:
This first one above is the interest rate set by the Central Bank of Turkey. It is the interest rate one can borrow from the Central Bank of Turkey, short-term. Notice how on average, between 2010 and 2017, the rate was about ~ 6%. Now let’s compare this interest rate to the rate on US Dollars, set by the United States Federal Reserve, below.
Notice that in the US, interest on US Dollars was 0.25% between 2010 and 2016, and since has gradually increased, until today, where it sits at 2.5%.
The Wall Street Journal pointed out something subtle, but extremely important:
“…[of] big concern is the amount of debt Turkey owes in other currencies, which the IMF says stood at 53% of gross domestic product at the end of 2017. Over a third of that comes due within a year, while 40% is in floating rate debt, making it more expensive to pay off as interest rates rise.”
Think of floating rate debt as like an Adjustable Rate Mortgage. Floating rates are also used in determining Home Equity Loan rates. Floating rate means the rate goes up and down with the market for interest rates. The market for interest rates on US Dollars is determined by the Federal Reserve. As we see above, that rate is rising. Turkey’s issue is that there is technically no ceiling on the interest rate it might have to pay on its Dollar Denominated Debt. By the way, according to this CNBC article,
“…Turkey’s reserves are notably low compared to its $181 billion in short-term debt denominated in currencies other than the lira. On top of that, much of the foreign currency in Turkey is held by banks, and those funds could be withdrawn by customers…”
$181 Billion! And its short-term debt, which is the part of the maturity curve that is most sensitive to the actions of the central bank, in this case, the Federal Reserve (since the debt is US Dollar denominated).
So Turkey got hit with a double whammy! It only took a slight increase in the US Dollar interest rates to suddenly get people worried about Turkey’s US Dollar debt. Why? Because as the Federal Reserve increases rates, it is also reversing Quantitative Easing. This means it is selling its portfolio of US Treasuries, and taking US Dollars out of circulation. Remember earlier, we said that banks sold their treasuries to the Federal Reserve in exchange for cash. Now the Federal Reserve is reversing that; it is selling out those treasuries, taking cash out of circulation. This means there are fewer Dollars out there, which makes the value of the Dollar go higher against other currencies, especially those currencies that have Dollar denominated debt, like the Turkish Lira!
So the double whammy was that the value of the Lira went down against the US Dollar, as we can see from the above chart. This meant it would take many more Lira to pay back US Dollar debt. This put fear into the market. Lira investors sold the currency out of fear the Turkish Central Bank would have to print Liras in order to pay their debts. This caused an inflation spike, which reinforced the decline of the Lira.
This in turn forced the Turkish central bank to take interest rates from ~8% all the way up to near 25%! They had to do this in order to give investors incentive to own Lira denominated debt and Lira currency. As you can see, since early August, it has temporarily worked to stabilize the currency.
Of course, if the Federal Reserve continues raising rates on the US Dollar, this will put more pressure on the Lira, and Turkey’s interest rate may have to go even higher.
It also doesn’t help Turkey that Donald Trump has begun sanctioning Turkish individuals. As a matter of fact, that political situation was the domino that tripped Turkey into crisis. The sanctions scare foreign investors into thinking politics will affect their investments, and drives them out of Turkey. The importance of political stability to foreign investors cannot be overstated If that situation continues to escalate, it will be even worse for Turkey than it is now.