Rate hike to stem lira sell-off

On Sunday (04.12.2016) the Turkish government announced it was taking steps toward launching state tenders in the lira currency, following President Recep Tayyip Erdogan's call on Turks to cash in their foreign exchange holdings under the mattresses and buy lira.

In the opinion of economists, the unconventional measures are unlikely to lift the pressure off the country's struggling currency. QNB Finansbank economist Deniz Cicek said he didn't believe demand for the lira would be boosted by state tenders.

"It's obviously ideal to make all contracts in the national currency, but it should be highlighted that the reason those contracts were made in foreign exchange was about the fact that the trust in the lira is low. Under this circumstances it will be difficult for firms to find long-term funding in lira," he told DW.

The Turkish lira has been under pressure due to rising regional tension, political uncertainties in Turkey amid widening concern about a crackdown following the July 15 failed coup, and a strengthening US dollar after the election victory of Donald Trump. The currency is among the biggest losers among its emerging peers.

Rate hike needed

Apart from his call on Turks to exchange their foreign currency holdings, Erdogan also urged the Turkish central bank to lower interest rates. After Erdogan's speech the lira tested new all-time lows against the dollar and fell to 3.60 lira versus the greenback.

Economists see interest rate hikes as the only way to support the lira. "Turkey may announce steps regarding foreign exchange liquidity. But I don't really expect any measure other than a rate hike to make an impact," said Inan Demir, a London-based emerging-market economist at Nomura.

Last month, the Turkish central bank raised interest rates for the first time in nearly three years, lifting its benchmark rate by 50 basis points, to support the lira and subsequently boost economic growth. 

However, this hasn't changed the lira weakness, and increased pressure to tighten monetary policy further in the coming months.

Low market confidence

Rabobank strategist Piotr Matys said that the announcements had failed to restore market confidence.

"Prime Minister Yildirim attempted to reassure foreign investors that capital controls will not be imposed. Such comments, however, are unlikely to restore market confidence that was shattered by turbulent events in Turkish politics and the outcome of the US presidential election," he said.

Matys blames domestic and external factors for the crisis of confidence in the lira, underpinning investors' bearish mood about the currency. He thinks the lira will remain vulnerable until confidence in government policy is restored.

Vicious cycle

Recent data from the Central Bank have shown that resident deposit holders are increasing their foreign exchange holdings despite continuing lira weakness.

Nomura's Inan Demir warns that the lira may enter a vicious cycle if the central bank will not step in with a sharp rate hike.

"This suggests expectations for a weaker currency are driving FX purchases, which in turn drive the currency weaker - the very definition of a vicious cycle. We think the central bank needs to step in with a large hike to break this vicious cycle."

However, such a drastic move would hit growth, Demir said, warning, however, that "letting the currency depreciate further and wreak havoc with corporate balance sheets" would be much more severe.

According to central bank data, Turkish corporations have net foreign exchange short positions of around $212.8 billion.