Lira sinks after money market dysfunction rattles investors

The Turkish lira has come under renewed pressure against the dollar, a day after short-term borrowing costs signalled that the country’s money markets were starting to malfunction.

Through most of June and July, Turkish authorities succeeded in pinning the dollar to less than TL6.85, even while the lira tumbled against other currencies. But the lira weakened beyond that point last week, and on Wednesday, the dollar jumped as high as TL7.05 to mark the lira’s lowest point since May 12.

The lira’s latest tumble comes a day after the costs of borrowing the currency overnight skyrocketed close to the record intraday highs struck in March last year. The offshore overnight swap rate — the cost to investors exchanging foreign currency for lira over a set period — hit an annualised level of more than 1,000 per cent on Tuesday from 30 per cent the previous day, according to Refinitiv data.

Analysts and investors said the abrupt jump in the overnight rate, to levels generally seen only in times of broad market tumult, was a symptom of Turkey’s increasingly dysfunctional money markets and presented a fresh risk for the lira and other assets.

Line chart of overnight swap rate (annualised %) showing spike in Turkish overnight rate a symptom of money market dysfunction

“The extraordinary situation at the start of the week came as Turkish
lira liquidity in international markets dried up,” said Enver Erkan, economist at Tera Securities in Istanbul.

Mr Erkan said that with the swap market in effect frozen, there was “serious” selling in Turkish stocks and bonds as foreign investors scrambled to meet their lira liabilities. The Borsa Istanbul 100 stock index shed more than 3 per cent on Tuesday while the prices on lira-denominated debt fell, pushing yields higher.

The money market tumult, which appeared to ease on Wednesday, came as the central bank lodged a fierce battle to defend the lira, according to emerging market analysts.

Goldman Sachs estimates that in the first six months of the year, Turkey’s central bank spent more on propping up its currency than during the whole of 2019, with $65bn of reserves deployed compared with $40bn last year. That kept the key rate against the dollar in check for a time, but the lira still sank heavily against other currencies such as the euro.

“The Turkish lira could be on the brink of yet another precipitous fall versus the dollar,” said Piotr Matys, strategist at Rabobank. Fluctuations in the lira over the past two weeks suggested the state lenders that act on behalf of the central bank to support the lira were “struggling” to keep it from falling more aggressively, he added.

These heavy interventions have severely eroded Turkey’s foreign currency war chest, depleting the country’s ability to fight any potential future runs on the lira. It also “undermines the credibility” of the central bank, Murat Unur at Goldman Sachs said.

One simple way to support the lira would be for the central bank to raise interest rates. That task is more complicated now, given the global impact of coronavirus, which has devastated the country’s crucial tourism industry. But even before the virus broke out, the central bank was cutting rates, reflecting deep disdain for higher interest rates from President Recep Tayyip Erdogan.

Line chart of Lira per US dollar showing Turkish lira selling intensifies

The central bank has slashed its key rate by about 15.75 percentage points in the past 12 months, in an attempt to encourage lending and to boost the domestic economy. The dollar has gained more than 18 per cent since the start of the year against the Turkish currency.

“I suspect the next step should be emergency rate hikes if the currency stays under pressure like this,” said Ed Al-Hussainy, a senior rates and currency strategist at asset manager Columbia Threadneedle.

Mr Unur concurred that rate increases will be necessary to ease the pressure on the lira and avoid the type of inflation boom that has hampered Turkey’s economy during recent periods of market stress. He expects the country’s benchmark rate to reach 10 per cent by the end of this year from 8.25 per cent at present, with 1 percentage point increases every quarter in 2021.


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