ANKARA/ISTANBUL (Reuters) - The Turkish lira was back in free fall on Thursday, dropping 5 percent as liquidity returned to a key London foreign-exchange market, prompting President Tayyip Erdogan to blame the currency’s weakness on attacks by the West.

FILE PHOTO: Posters of U.S. dollar and Turkish lira are seen on a currency exchange shop in the city of Azaz, Syria August 18, 2018. REUTERS/ Khalil Ashawi/File Photo

After a major liquidity squeeze pushed the London swap rate to a record 1,200 percent on Wednesday, Erdogan told young voters in a campaign event that some banks were playing a game with the currency ahead of nationwide local elections on Sunday.

The lira has been hit by a sweeping lack of confidence among Turks, leading them to snap up record holdings of dollars and gold. Uneasy relations with the United States and concerns about post-election government policy also hurt sentiment, beginning with a more than 4 percent fall in the currency last Friday.

As lira liquidity improved on Thursday, the London overnight swap rate plunged to 35 percent from the crippling 1,200 percent a day earlier, Refinitiv Eikon data showed. It had stood at 24 percent last week.

A senior official earlier told Reuters: “We made it clear that this process would not continue for long. It was a step against a speculative attack and it has ended. We do not expect a new speculative attack.”

But two senior bankers said this comment did not reflect the reality and it was not true that banks had only started providing liquidity again on Thursday.

“The assessment that local banks have restarted providing lira to the London swap market does not reflect the truth. Banks are behaving in line with their commercial obligations,” one banker said.

Turkey’s finance minister said Turkish banks were providing billions of lira to foreign markets and normalisation in market conditions, both locally and in London, had begun.

Speaking to Turkish broadcaster NTV, Berat Albayrak said Turkey would enter a reform period after elections but did not provide specific details as to what the government plans to do.

He said the framework of steps to be taken may be announced in the week of April 8 if the plan is ready.

The lira weakened as far as 5.6465 per U.S. dollar from 5.33 on Wednesday. Last year, it plunged almost 30 percent against the dollar. At 1431 GMT, it stood at 5.5900.

Sources had previously said lira liquidity would be squeezed until after Sunday’s local elections.

Rabobank emerging market forex strategist Piotr Matys said the market was braced for a volatile week for the currency after local elections on Sunday.

He said it was critical that Finance Minister Berat Albayrak announce a detailed package of reforms to preserve what is left of “Turkey’s severely damaged credibility”.

“His remarks since the lira crisis last year imply that he is fully aware of what investors expect from him. It is time to deliver,” Matys said.

“The response from the administration to the outcome of this crucial vote – seen by many as a referendum on President Erdogan and his executive powers - will be critical for the lira and local assets,” he added.

DISCIPLINE MARKET SPECULATORS

Erdogan said Turkey had thwarted attacks on the lira by the United States and the West generally.

“We must discipline the speculators in the market,” he said. “They can’t find lira now, they are struggling in terms of payments. The tables have turned. While they can’t do this, the lira firms and dollar falls.”

Erdogan also said Turkey must cut interest rates so that inflation falls, a view that counters that of many economists.

“The real problem is interest rates. I’m also an economist,” he said.

The central bank has taken a series of steps to underpin the lira this week, and bankers said it took one more on Thursday, raising its total lira swap sale limit to 30 percent from 20 percent for swap transactions that have not matured.

It had raised the limit to 20 percent from 10 percent on Monday in a bid to boost the bank’s forex reserves, which fell sharply in the first two weeks of March.

Those falls have raised uncomfortable questions about Turkey’s balance of payments and its ability to roll over its foreign loans - and how and from whom it would seek emergency reserves if necessary.

Central Bank Governor Murat Cetinkaya said on Thursday the bank continued to strengthen its reserves “decisively”, state-owned Anadolu news agency reported.

Total reserves last week increased by $4.3 billion to $96.7 billion as of March 27, Cetinkaya said. He said net reserves rose $2.4 billion to $28.6 billion in the same period.

Total forex deposits and funds, including precious metals, of Turkish local individuals and institutions hit a record high of $179.3 billion in the week to March 22, data from the central bank showed on Thursday.

Albayrak said locals had begun converting foreign currency holdings to Turkish lira and he believed the conversion of foreign currency deposits to lira will accelerate.

This week’s spike in the overnight swap rate posed a huge hurdle to foreign investors looking to bet against the lira. They had instead sold off holdings of Turkish stocks and bonds, which have come under heavy pressure this week.

As the currency dropped on Thursday, the cost of Turkey’s debt rose, with the yield on the benchmark 10-year bond climbing to 18.50 percent from 18.21 percent on Wednesday. It has risen two percentage points since last week.

Albayrak also said he expects Turkey’s share and bond markets to normalise in coming days.

The Istanbul share index, which weakened more than 12 percent in the week to Wednesday’s close, rose 2 percent.