Why we all should pay more attention to the Turkish Lira than Evergrande and the Chinese Financial Market (Updated 25th December)

In the following I will briefly describe, how the Turkish Financial Market could have an impact onto European Financial Markets and is already having onto Bitcoin (and other crypto assets).

The situation

The inflation in Turkey has been spiraling out of control in recent years. Annual inflation reached over 21% on an annual basis and the Turkish national currency has plummeted over 45% against the dollar in this year alone (below a 25Y USDTRY-chart)

The reasons for this are as diverse as they as persistent:

(1) high public sector budget deficits (2) monetization of public sector budget deficits (3) massive infrastructure investments of the various governments, such as for the Southeastern Anatolian Project (4) high military expenditures associated with geopolitical reasons (5) political instability which results in inflationary pressures due to populist policies that have ensued prior to each general election (6) persistent inflationary expectations of economic agents (7) inflationary effects of changes in exchange rates via increases in prices of imported inputs (8) occasional increases in world prices of major imported inputs (particularly, crude-oil) (9) increases in regulated prices of public sector products which are mainly used as input by the domestic private sector, and/or (10) rising interest rates resulting from the crowding-out effect of public sector borrowing in a shallow domestic capital market.?

Why is this relevant?

While what we have seen in recent months seems not as big of an issue as the seemingly looming default of Evergrande in China, there are a few reasons why the impact of the Turkish Lira could be felt much wider than generally anticipated.

I will not go into detail about the Chinese Financial Markets, but in a nutshell the reasons for Evergrande having a limited blast radius are:

1. The Chinese government has the necessary resources to intervene and stabilize markets, if necessary (even if this means a controlled explosion).
2. The Chinese Financial Markets are largely isolated, especially as currency controls, currency status etc. are in place and would in a first instance only affect Chinese banks and investors into the Chinese bond and equity markets.
3. Given that all larger banks are owned by the government, measures like forced buying of Evergrande-issued bad bonds could be implemented, allowing for a balanced hit to all participants' assets.

How is Turkey's case any different?

Due to the recent developments many foreign banks have pulled out of Turkey and realized their losses (e.g. ING and Unicredit to name a few). As Erdogan has been replacing Central Bank Chairs as if there is no tomorrow, surely there is no point in learning any names, as the role equals a revolving door for the time-being. On one hand, there seems to be to some extent a general misunderstanding between economic policies and the effects thereof on the political end of the Turkish leadership. On the other hand, the reasons for the current policy and avoidance of drastic measures can be found in the upcoming election cycle. While measures like raising interest rates etc. (more details later on), would be very painful in the short-term, they would allow for a steady recovery in the long run.

So far the Turkish Central bank has been intervening by selling $3.1 billion of foreign exchange in spot markets. For the overall foreign reserves, when swaps and other liabilities like required reserves are stripped out, Turkey's net reserves stand at negative $35 billion. So there is almost no room for leverage.

Luckily Turkey is the 9th-11th largest holder of gold reserves (depending on the statistics at hand) with 407.6 tones as of July 2021. The monetary authority set a new limit on the amount of gold banks are allowed to hold as their lira reserve requirements, which will effectively result in a sale of gold and an increased amount of local currency being parked at the central bank (therefore taking some liquidity out of the market). If and to what extend gold reserves can and will be used to combat inflation is to be seen. A large scale sale of gold would most likely further destabilize the currency (as imminent following effects).

The link to Europe and the European Central Bank

As mentioned above, most of foreign banks pulled out of the Turkish market and are awaiting to see when the situation stabilizes. But there is one exception: BBVA. The second largest Spanish bank is among the world's largest financial institutions, rivaling players like Barclays (UK) and BNP Paribas (France) in overall asset volume.

BBVA bought its first stake in Garanti about a decade ago and then increased its position to just under 50% in 2017. It represents the third-largest market for BBVA (profit contribution). In November this year, BBVA made a bid to acquire the remining 50.15% for $2.6 billion. The CEO Carlos Torres Vila explained the deal as the following:

"We are selling at a very, very attractive price in the US and we are buying at a very, very attractive price in Turkey."

In actual terms, this means selling BBVA assets at 20 times earnings in the US and buying at roughly 3.6 times earnings in Turkey. While this might be seen by many as a smart move, this is a quite risky endeavor, especially as BBVA could not have foreseen the depreciation of the Turkish Lira to the extend it does and therefore a discount on Garanti. This would be like me recommending someone to buy penny stock today and then when it drops in a week by 30% to tell them to buy more, as this represents a huge discount when compared to the original investment. What in my view matters most is the investment quality, not its price, as price and quality (underlying value) will eventually find their equilibrium. So if BBVA's investment in a bank, that has assets denominated in a dying currency proves to be a full write-off, the Turkish problem becomes a European one. The European Central Bank will need to step in to stabilize markets.

What does this have to do with crypto?

Turkey and the Turkish population have been among the highest, if not the highest adopters of Bitcoin and other digital currencies. The reasons for this can be generally found in a higher level of distrust into the government and also finding ways of storing value, which are outside of traditional markets and government access/supervision.

While Bitcoin has an implied volatility of about 70, the Turkish Lira's IV is at about twice this number. Now what could be effects that we can expect? Most likely the Turkish population is going to try to get rid of any Lira and switch into first other fiat currencies where possible, into harder assets (commodities) and ultimately into digital assets, as commodities such as gold are not very portable and it is much easier for the government to enforce a ban on gold, than one on digital assets.

Conclusions

1. The only measure that can save the Turkish Lira from dropping even further is to raise interest rates drastically as Paul Volcker did in the US in 1981 (but not only to 20% as in given example, but rather 50%+).
2. Watch how BBVA and their investment into Garanti plays out and what impact it could potentially have on other markets.
3. This is a classical example of a fiat currency becoming "softer" than a digital currency. As we are currently seeing relative US dollar strength and many emerging markets' debt is denominated in this currency, we can expect more emerging countries to struggle with repayment and trying to solve the situation by inflating their way out and/or asking for an IMF bailout.

Update

I will not go into detail about the desperate measures the Turkish government is implementing, trying to stabilize the Turkish Lira. What I would like to mention is that Forex Trading itself is a highly riskly matter. The people of Turkey are forced to become day traders, with already half of all cash reserves held are in foreign currency. A one-sided plundge of the Lira is not the worst scenario, instead we should image a remaining high realized volatility, which is above 100 (or twice Bitcoin). As a family you are are forced to sometimes pay a premium on cooking oil or other essential goods, which is one of the side effects of the current monetary policy, this is the worst potential scenario. As mentioned Erdogan is running for elections next year. With the Central Bank and therefore the economy being in his hands, this might lead to geopolitical volatility (as a distraction), which will effect commodity volatility, which creates higher global volatility (as we live in a globalized world economy).

Final Result: The Turkish Lira will continue to get crushed in the long run.

Sources:

1. https://www.aljazeera.com/economy/2021/12/1/turkeys-central-bank-sells-foreign-reserves-to-stem-lira-crash
2. https://www.aljazeera.com/economy/2021/12/3/turkey-central-bank-intervenes-again-to-shore-up-embattled-lira
3. https://www.bbc.com/news/world-europe-59487912
4. https://econwpa.ub.uni-muenchen.de/econ-wp/mac/papers/0107/0107002.pdf
5. https://www.reuters.com/article/uk-turkey-cenbank-governor-idUSKBN27N025
6. https://tradingeconomics.com/turkey/currency
7. https://www.washingtonpost.com/local/obituaries/2019/12/09/c744d596-1468-11e1-9048-1f5352187eed_story.html
8. https://www.statista.com/statistics/277044/inflation-rate-in-turkey/
9. https://tradingeconomics.com/turkey/gold-reserves#:~:text=Gold%20Reserves%20in%20Turkey%20averaged,the%20fourth%20quarter%20of%202012.
10. https://www.bloomberg.com/news/articles/2021-11-09/turkey-s-central-bank-tweaks-reserve-rules-to-cut-lira-liquidity
11. https://www.bbva.com/en/bbva-to-launch-takeover-bid-for-remaining-50-15-percent-of-turkish-franchise/
12. https://www.theguardian.com/world/2021/sep/21/evergrande-will-it-collapse-and-what-would-happen-if-it-did