LONDON (Reuters) – Turkey’s latest squeeze of its $37 billion-a-day London lira market may succeed in boosting scarce hard currency reserves but analysts say it will not stem the lira’s decline and that the country’s reliance on foreign capital means it could backfire.
The Turkish banking watchdog announced on Sunday it was capping local banks’ ability to conduct foreign exchange swap, forward and option transactions with foreign entities at just 1% of each lender’s equity, down from 10% previously.
That effectively constrains Turkish banks’ ability to lend lira overseas, squeezing supply of the currency. Lenders discouraged from opening swap positions with counterparties abroad might also bring the money home, analysts said.
The step, which follows a 14% decline in the lira year-to-date does not seem to have surprised markets — possibly because Ankara, convinced that offshore trade is the driver of lira speculation, has resorted to such tactics before.
“Even pre-corona and during a number of homemade crises, we have seen a tendency in Turkey to veer towards controlling flows of capital, often through controlling the freedom of FX traffic in London,” said Ulrich Leuchtmann, head of FX strategy at Commerzbank in Frankfurt.
Leuchtman said ultimately such capital curbs can damage lenders’ willingness to meet a country’s financing needs. The offshore market, moreover, greases the wheels of the billions of dollars in foreign investment Turkey draws each year — direct bricks-and-mortar commitments as well as stock and bond flows.
Stakes are high, given a current account gap that was $1.2 billion in February and the government’s urgent need to pump stimulus into the economy to counter damage from coronavirus.
A similar squeeze on offshore lira markets last year pushed overnight borrowing rates to over 1,000% and briefly lifted the currency. This time, lira swap rates <TRYCCSONZ=R> slipped to minus -8%.
Traders said international banks had broadly been “long” lira, which they would normally place with Turkish banks. But the new rules restrict them from doing so, resulting in excess lira and negative funding rates which one currency trader called “absurd”.
Graphic – Turkey balance of payment: https://fingfx.thomsonreuters.com/gfx/mkt/yzdvxgxepxe/Turkey%20balance%20of%20payment.JPG
Analysts at BofA calculate Turkey’s current banking sector capital at about $100 billion, so under the new rules, volumes of lira swaps banks can transact overseas would shrink to below $1 billion.
On Sunday, Turkey’s banking watchdog BDDK said it made the change to support measures taken to protect financial stability and manage risks raised by the global coronavirus outbreak.
The BDDK did not respond to requests for further comment.
Analysts said the move may be motivated less by the desire to lift the currency and more by a need to rebuild reserves.
“Banks would gradually bring offshore swaps to onshore with the CBT (central bank), which should help the CBT’s net international reserves,” Ferhan Salman at BofA told clients.
Turkey’s net international reserves fell to $27.14 billion last week, some $5 billion lower than a week earlier and down from over $40 billion in early January.
Investors are worried that depleted forex reserves could hamstring the response to a pending recession brought on by measures taken to halt the spread of COVID-19.
To make up for smothering offshore markets, Turkey has opened a domestic swap market under Borsa Istanbul. Local banks have started to use this facility but foreign investors prefer offshore markets, where it’s easier to get credit lines with international lenders.
The restrictions could exacerbate recent declines in overseas lira trading. Average daily lira trading volumes in London had shrunk to $37 billion last October, from $51 billion in 2016, while its share of total FX trading slipped to 1.3% from 2.3%, Bank of England data shows.
Graphic – Turkish lira in offshore markets: https://fingfx.thomsonreuters.com/gfx/editorcharts/jznvnmkaplm/eikon.png
Turkey’s playbook of tinkering with offshore currency markets isn’t new — several countries, from Thailand to Iceland, have tried to stifle offshore markets to prevent or halt currency runs.
But Turkey may find it harder to shield the lira in this manner. First, its own citizens’ rush for dollars is probably a bigger source of currency pressure than foreign speculators — they held a record $201.7 billion of forex last month, though levels have since come down a bit.
Second, Turkey is trying to achieve the “impossible trinity”, said Okan Akin, a strategist at AllianceBernstein.
“It is a typical case of trilemma — you cannot control both currency and interest rate levels in an economy with open capital accounts,” Akin said.
He noted Turkey remains reluctant to hike interest rates to defend the currency, instead making its seventh consecutive cut in March.
Foreigners in need of lira might meanwhile opt to sell their Turkish equity and bond holdings, Goldman Sachs analyst Murat Unur said, “which is likely to form another source of pressure for the currency”.
(Reporting by Karin Strohecker in London, additional reporting by Sujata Rao on London and Nevzat Devranoglu in Ankara and Ebru Tunkcay in Istanbul; Editing by Sujata Rao and Catherine Evans)