Divestor

Lots of headlines are being made about Turkey and its currency, the Turkish Lira:

(The chart with the Turkish Lira to US dollar is very similar).

(Wikipedia Article on the matter)

Turkey’s GDP is about half of Canada’s (i.e. not an insignificant economy).

A lot of the cause of the currency depreciation appears to be the leveraged borrowings in foreign currency by domestic companies coupled with the domestic government wanting to keep interest rates lower than the prevailing market rate.

As a result, the purchasing power of the domestic currency has declined significantly. Even the basic math of accounting changes when dealing with a rapidly inflating currency. Just imagine marking up all of that foreign debt on each quarterly financial statement – normally the foreign currency translation adjustment component of equity on the balance sheet is some small fraction of the overall picture, but in this case, comprehensive earnings becomes a very important figure to watch – your business might be making 500 units of profit, but if foreign currency liabilities increase by 5,000 units of domestic currency, you’re toast!

Since Turkish inflationary headlines have reached the mainstream, chances are there is some actionable ideas, but I am not enough of a macroeconomic professional to truly figure out where things are headed.

On the domestic side of things, Turkish stocks have been a better store of value than pure Lira:

The preceding chart is the iShares MSCI Turkey ETF, the only broad-based Turkey ETF I could find. It is denominated in US Dollars.

Despite the Lira depreciating 75% over the past five years to the US Dollar, the ETF has “only” lost about 25% of its value denominated in US Currency.

Obviously, when the companies that constitute the index have heavy amounts of foreign currency debt, the equity will be taking a considerable hit as companies try to service these debts with domestic cash flows. However, with the currency depreciating at the rate it does, it amounts to an effective interest rate on foreign debt that is very high. One possible conclusion is that there will be a foreign debt default with a subsequent recapitalization and/or nationalization of various strategic entities as I very much doubt the Turkish government wants its major companies to be foreign controlled.

The stock market is thus not a very good retreat if you are forced to live with a currency in a very inflationary environment. This has also shown to be true in other jurisdictions – initially the stock market makes huge gains (everybody is looking for a shelter for depreciating currency), but later the economic damages caused by high inflation rates eventually kills returns on the whole spectrum of the capital structure.

Indeed, there is a huge incentive to leverage at low interest rates (these debts would be repaid in much less real value) and purchase different assets, ideally liquid ones.

Holding USD itself (or Euro) would be a liquid store of value. A physical gold investor over the past 5 years not only would have made a 50% return in nominal US dollars, but the gains would be much, much higher in Turkish Lira. Having a mechanism of storing crude oil would also be a liquid store of value. There are plenty of options, some feasible, some not.

Here in Canada, if companies issue debt in non-Canadian dollar currency, it is most likely to be in US Dollars. Since most of our trade is linked to the USA (we are functionally joined at the hip with them) it is unlikely that we will face the same mechanism of currency decline as Turkey. If our export market starts to evaporate (e.g. we shut down our fossil fuel and automobile industries in the name of climate change) we will be in serious trouble.

Just doing some general review and scribbling down some thoughts.

One is that the S&P 500 and TSX are up 25% and 23% year to date:

This is likely induced by monetary policy, with the US and Bank of Canada historically demonstrating a huge amount of QE:

The central banks have signaled that this party is slowing down.

Picture the flow of a notional dollar of capital from monetary policy.

Monetary policy has the Bank of Canada purchase a bond from a primary dealer (one of the big banks). The result is a BoC asset (government debt), and liability (reserves due to the bank). The big bank receives reserves as a credit at the Bank of Canada, which they can use to make loans. Customer X goes to the big bank and sees something that warrants taking out a loan. Big bank lends a couple dollars to Customer X (loan is the bank’s asset, Customer X has cash, at the cost of a yearly cash flow from customer (debit interest expense, credit cash) and to the bank (debit cash, credit interest revenue). QE makes it “possible” for the big bank to execute on this loan as they can do so more cheaply than if QE wasn’t in place, effectively making credit ‘cheaper’ and thus lowering the rate of interest.

In this scenario, the bank is the one suffering the default risk, and this dollar given to Customer X is not given to him by the central bank, so it is not money printing. The loan must be paid back, with interest.

Customer X takes the loan, and invests it in some widget machine with Company Y. Company Y takes the money to pay labour and materials needed to make the widget machine. The labour tends to spend it on various necessities (food, housing, consumer goods, etc), while the materials provider has to spend it on their payroll (labour) and capital equipment from Company Z, A, B, etc.

All of this is illustrating the flow of where the notional dollar of capital is generated and circulated – originating from a financial institution (the point of money creation) and circulating in the economy. Eventually profits from companies Z, A, B, etc., circulate into shareholder hands, and for the very rich that have nothing else better to do with capital (there is only so much food and drink and housing one can buy), gets slammed back into the equity market.

Clearly there is a point where you can just bypass all of this widget creation and just invest loaned capital into the equity markets directly, which seems to be the result of what has happened. The notional dollar does not get created or destroyed, but the path of where it flows is quite relevant. Depending on the speed it flows (monetary velocity) and where it flows, the economic outcomes wildly vary.

For instance, imagine a world where 99.9% of the cash is held in the hands of day-traders only, circulating amongst them within the Nasdaq and NYSE, and these participants have no interest at all in building widget machines. We seem to be increasingly in an environment where a lot of this capital is held in the financial and not real world.

When money bubbles out of the financial world into the real world, this is when we start seeing a chase up the prices for real assets. For instance, going back to our fictional world where day traders own 99.9% of the financial capital, they might discover that they need to eat food. But since the food markets have been so malnourished, all the day traders can do is just keep bidding up the few morsels of food remaining, until prices reach some absurd high – a typical hyper-inflationary scenario. Indeed, if the day-traders have to eat 100 units of food, and only 70 units of food are available, there is no amount of financial capital available that can satisfy the demand.

One can imagine that the high amount of financial capital available would dramatically increase the volatility for real goods and services when the carriers of financial capital recognize an imminent need.