Turkey was teetering on the edge of a full-blown currency crisis on May 23 as overnight selling by Japanese traders cutting their losses sent the Turkish lira (TRY) towards a startling 5.0 to the dollar and the country’s central bank remained sat on its hands.

The freefall weakened the TRY 5.5% taking it to a fresh record low of 4.9294, prompting discussion among analysts as to how much monetary tightening would be needed from the central bank, should it show the required independence to go against the unorthodox and contrarian demands for loosening made by President Recep Tayyip Erdogan. Some analysts speculated that even a hike of 400 basis points might not do the trick.

Lira bears on the market said that if the rout turned into a genuine currency crisis Turks would start selling lira too, creating a total loss of confidence. The lira’s 21% loss in the year to date is the second worst in emerging markets, and is nearing the decline experienced by Argentina’s peso.

Timothy Ash, senior emerging markets sovereign strategist at BlueBay Asset Management, said in a note: “Brutal truth is we now know [the lira] is a floating currency. Turkey never had enough reserves to defend the exchange rate. Erdogan made a choice between letting the currency go and/or hiking rates and for his particular political calculation he opted to let the currency go.

“The currency adjustment will help rebalance the current account deficit but it will crimp growth [ahead of the June 24 early elections]. Not sure Erdogan gets that and this will also slash import demand. But the FX hit to domestic confidence and growth will be significant.”

The Central Bank of the Republic of Turkey (CBRT) will inevitably have to respond to the foreign exchange pass through to inflation by hiking rates either at its next scheduled policy meeting on June 7 or before, concluded Ash.

Recession risk

Jason Tuvey of Capital Economics said in an emailed note that Capital expected the central bank’s monetary policy committee to hold an interim meeting over the coming days to raise interest rates by at least 200bp. “If policymakers refrain from tightening monetary policy, the risk of a disorderly adjustment and a sharp economic downturn (possibly recession) will mount,” he added.

Piotr Matys, an emerging-market currency strategist at Rabobank in London, responded to the latest lira turmoil by telling Bloomberg: “When retail investors capitulate — as has been the case overnight when Japanese margin traders decided to cut their mounting losses on their long lira positions against the yen — one could argue that it is a contrarian signal that perhaps the worst is over. But it is crucial that the central bank acts quickly and decisively by announcing within the next few hours that it will hold an emergency meeting due to the latest market developments.”

He added: “Only a few weeks ago I would have argued that 200 basis points should have been sufficient, but following such significant depreciation the central bank may have to seriously consider at least a 400-basis-point hike to restore confidence in the lira. Even that may not be enough if [CBRT] governor [Murat] Cetinkaya is not fully supported in his attempts to stabilise the currency by prominent Turkish officials.”

“The people have seen the puppet and puppeteers”

Though Erdogan — who often points to foreign market conspiracies being mounted against Turkey’s economy — stayed silent on the collapse of the TRY, Turkey’s government spokesman said on May 23 that a game was being played with the lira but it would not change the outcome of next month’s election, state-run Anadolu Agency reported. “The people have seen the game and the player. The people have seen the puppet and puppeteers. They will not allow them or give an opportunity,” Deputy Prime Minister Bekir Bozdag was quoted as saying.

In an effort to boost the lira — mired in something approaching a perfect storm of domestic and global economic negatives including an overheating Turkish economy, double-digit inflation, Erdogan’s apparent interference in monetary policy, the growing attractiveness of yields on US Treasury paper and likely Fed hikes ahead — the Istanbul stock exchange said it had converted its foreign-exchange assets to TRY.

There’s no economic data that justifies the lira’s current depreciation, Borsa Istanbul said in a statement, referring to “speculative approaches” before the snap presidential and parliamentary elections aimed at showing Turkey’s economy in a bad light.

“As an indication of our confidence in the Turkish lira, our exchange’s foreign-currency assets, excluding short term needs, have been converted to lira as of today,” the bourse said.

However, the data continued to weigh against the optimists with the implied volatility of the TRY over the next month soaring to the highest in nine years, eating into the currency’s appeal to arbitrage traders.

The benchmark BIST-100 index on the Borsa Istanbul was down 1.15% d/d to 102,144 as of 16:00 local time while the yield on 10-year domestic bonds had reached 14.69% and the yield on two-year domestic bonds stood at 16.71%. By 16:40, the TRY had trimmed its losses against the dollar. One dollar bought TRY4.8532.