Turkey lira crisis is being caused by the US Fed

The US Federal Reserve’s balance sheet since the 2008
crisis.
FRED

• 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:

FRED

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:

Finviz.com

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:

Yahoo
Finance

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:

Yahoo
Finance

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:

Deutsche
Bank

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: