Global financial markets were roiled this past week as Turkey's currency lost approximately one-third of its value after the U.S. placed sanctions on the country in retaliation for holding an American pastor under house arrest. Market participants have been fearful of a contagion spreading throughout emerging markets, which were already struggling this year due to the surging U.S. dollar, rising interest rates, and the tightening of U.S. monetary policy. Though most commentators have focused on the sharp decline of the lira currency, my primary concern is the popping of Turkey's credit bubble that I warned about in Forbes in early-2014.
Since my last Turkey warning, the lira currency has lost approximately two-thirds of its value:
In order to shore up the lira after its sharp decline, Turkey's central bank hiked its benchmark interest rate from 8% to 17.75% in May (see chart below), ending a period of unusually low interest rates that lasted for almost a decade. In addition, there may be more rate hikes ahead due to the past week's lira decline.
Turkey's 10-year government bond yield has also spiked as the country's bond market sold off heavily as a result of the tightening of U.S. monetary policy and the rising dollar.
This sell-off confirms the concerns I discussed in my 2014 report:
Rock-bottom interest rates in the U.S., Europe, and Japan, combined with the U.S. Federal Reserve’s multi-trillion dollar quantitative easing programs, encouraged a $4 trillion torrent of speculative “hot money” to flow into emerging market investments over the last several years. A global carry trade arose in which investors borrowed at low interest rates from the U.S. and Japan, invested the funds in high-yielding emerging market assets, and pocketed the interest rate differential or spread. Soaring demand for EM assets led to a bond bubble and ultra-low borrowing costs, which resulted in government-driven infrastructure booms, alarmingly fast credit growth, and property bubbles in numerous developing nations.
Turkey's higher interest rates are a reason to worry because the country has a massive credit bubble that formed due to the unusually low interest rate environment of the 2010s:
Consumer credit has increased fivefold since 2010, as the chart below shows. Consumer credit is a major driver of Turkey's economy, as I explained in my original warning:
Accounting for 70 percent of Turkey's GDP, consumer spending has been the country's primary engine of economic growth in the past decade. Unfortunately, much of this consumer spending has been financed by debt, as with many other areas of Turkey's economy. Personal loans grew at a scorching 61 percent average annual rate from 2005 to 2008 and barely slowed down after the financial crisis, while loans to households were increasing at a 28 percent annual rate in 2013. Credit is so free-flowing in Turkey that consumers are even able to receive approvals for personal loans via text message and ATM machines.
In addition to personal loans, credit card debt has played a significant role in enabling Turkey's consumption boom, with credit card loans from the country's leading banks having risen by 77 percent from 2010 to mid-2013. Turkey's 74 million citizens now own 57 million credit cards and carry approximately $45 billion in outstanding credit card debt - nearly a third of which is considered to be nonperforming. Turkish consumers' embrace of debt-driven consumption has caused household debt as a proportion of disposable income to rocket from 4.7 percent in 2002 to 50.4 percent in 2012.
The chart of Turkey's domestic private sector credit as a percentage of GDP shows how credit has been growing at a much faster rate than the underlying economy since the early-2000s:
Low interest rates have also created a housing boom/bubble in which housing prices have increased by 172% since 2010. Higher interest rates are likely to create a housing bust in Turkey.
The plummeting lira poses a grave threat to Turkey's economy because of its high level of external debt (nearly $500 billion worth). External debt is borrowed in a foreign currency and becomes harder to service when the domestic currency weakens relative to the foreign currency. According to Societe General's Jason Daw, Turkey has $180 billion worth of short-term external debt and borrowing costs are now 25% higher due to the lira's recent weakness.
Turkey is on the verge of a credit and asset bust as a result of higher interest rates. Much of the discussion about Turkey in the financial media focuses on the recent U.S. sanctions, Turkish President Recep Tayyip Erdogan's saber-rattling, and the plunging lira, but the risk of a credit bust is being virtually ignored. It is important to realize that Turkey's economic problems did not begin with the recent spat with the U.S., but were already "baked into the cake" years ago.
We at Clarity Financial LLC, a registered investment advisory firm, specialize in preserving and growing investor wealth in times like these. If you are concerned about your financial future, click here to ask me a question and find out more.
