Disclaimer: The content from The Daily Reckoning Australia’s global cast of characters is their own view and opinion. It is not to be taken as investment advice.
24 June: A Critical Day in Global Finance
Donald Trump and North Korea are dominating headlines once again.
Have the two sparring leaders put their differences aside for the sake of global peace?
Either way, this media sleight of hand is intended to get you to look the other way.
In fact, the summit merely delays a potential conflict between the two countries by six months.
Before you know it, Christmas will be here, and rather than bells-are-ringing it will be a bombs-they-are-a-bringing.
Yet while your eyes were glued to the surreal events in Singapore, you missed the problem unfolding in Turkey.
Here’s what you missed:
Captivated by megalomaniacs, the rip beneath the surface of the global economy is being ignored once again.
Turkey. Argentina. Brazil. China. India. Mexico. The fault could show up in any emerging market.
The reason why you don’t hear about the emerging market problem more is because it’s complicated.
I should know. I’ve spent the past two months researching it.
My investigations lead me to believe that Turkey in particular stands out as a flashpoint that could set off an emerging market time-bomb.
For one, the falling value of the Turkish lira is spooking European markets, even if it’s yet to make its way to Aussie shores.
In the past five years, the lira has fallen 56% against the US dollar. At the same time, 10-year Turkish bonds have jumped to 15.75%. The high yield reflects the country’s BBB- credit rating and puts the government bonds squarely in the ‘junk’ category.
Keep in mind that the higher the bond yield, the riskier the debt. High-risk bonds have a high interest rate to compensate investors for the risk that they may never receive the full value of the investment.
Which is to say that Turkish and emerging market bonds in general aren’t for the faint-of-hearted.
In fact, there’s a chance the 10-year bond rate will spike higher in the coming days. The Turkish lira is expected to weaken further on the back of the Fed raising the funds rate to 1.75–2%.
Yet the weak lira is only one problem. The much bigger problem is the incredible amount of debt Turkey has.
Collectively, the Turkish government and banks owe about $590 billion to foreign creditors. On top of this, Turkish businesses have borrowed $448 billion in private, non-bank debt.
The danger here is that these loans are made in US dollars, and they have to be paid back in US dollars.
That poses a problem for the lira. For every 1% the lira falls against the US dollar, another five billion lira is needed to cover the loans.
Getting ready to default
I recently wrote on my Twitter account that I believe Turkey is getting ready to default on its loans.
After all, it’s deeply in debt, the lira is worthless, and it recently finished repatriating 220 tonnes of gold from the Federal Reserve Bank. In a situation in which it defaults on its loans, Turkey wouldn’t have to pay back the US dollar-denominated debt, and it’d get to keep the gold.
However, as a couple of astute Twitter users pointed out, Turkey only repatriated gold stored at the Fed, and not all of its gold holdings.
This is true.
Turkey’s remaining foreign reserves are kept in London.
The Central Bank of the Republic of Turkey (CBRT) ‘shares’ foreign reserve holdings with domestic banks. That means, of the 590 tonnes of gold and foreign cash reserves the CBRT claims to have on its balance sheet, roughly half is actually owned by domestic banks.
This sharing scheme means that the CBRT can call on Turkish banks to provide their own currency and gold as the collateral the CBRT needs.
Think of it like borrowing books at a library. The library owns the books, and you get to borrow them. Well, it’s the same with CBRT and its gold. The CBRT can borrow the gold, but Turkish banks are the owners.
What this tells you is that the Turkish economy is in a far more precarious position than you may think.
Furthermore, with the CBRT taking steps to bring belongings home and away from the US — where the Federal Reserve can’t hold it hostage — it leaves Turkey free to dodge obligations on its loans when it suits them.
When might that be?
Well, there’s an election in two weeks. For now the highly nationalistic policies of President Recep Tayyip Erdogan are endearing him to locals. Despite the economy going to pot and the lira becoming worthless, the Turkish public likes him. And they appreciate his anti-US dollar position.
So keep an eye on the first round of Turkish elections on 24 June. If Erdogan is sworn into power once more, a Turkish default may only be a few months away.
That could potentially trigger a wave of emerging market defaults in its wake.