Turkey's Central Bank Takes Measures to Prevent Lira Appreciation Amid Rising Foreign Inflows

Key Takeaway

• Turkey's central bank has purchased $43 billion in foreign exchange to prevent excessive lira appreciation amid rising foreign inflows.
• High domestic interest rates have attracted $16 billion in carry trade inflows since March, pressuring the lira to appreciate.
• Record foreign investment in lira bonds, with $5.5 billion net inflows over four weeks, reflects growing investor confidence and market-friendly policies.

Central Bank's Currency Management

Turkey’s central bank, previously criticized for selling reserves to support the lira, is now taking measures to prevent the currency from appreciating excessively. Finance Minister Mehmet Simsek has described the current situation as one of "excessive appreciation." To counter this, the central bank has injected hundreds of billions of liras into the financial system, which it now needs to absorb. According to Goldman Sachs Group Inc., the central bank's foreign-exchange purchases have totaled $43 billion over the past four weeks when adjusted for valuation effects.

The Turkish lira has shown a modest increase of about 0.4% against the dollar since a slump before local elections in March. This is in contrast to a gain of over 2% for currencies like South Africa’s rand. SEB AB has noted that the lira's managed currency approach now resembles that of the Chinese yuan and the Indonesian rupiah. Goldman economists Clemens Grafe and Basak Edizgil stated, “The problem facing the Turkish central bank has moved from FX weakness to the difficulty of avoiding a nominal appreciation amid rising foreign inflows and a more favorable current account seasonality and of sterilizing its FX purchases.”

High Interest Rates and Foreign Inflows

Turkey's domestic interest rates, the highest among the Group of 20 nations, are a significant factor in the lira's appreciation pressure. Central bank Governor Fatih Karahan emphasized that monetary policy would remain tight until inflation expectations decrease, with rate cuts expected no sooner than the final quarter of the year. This high-interest environment has created a substantial arbitrage opportunity for investors, leading to an estimated $16 billion in carry trade inflows since the March local elections, according to Bloomberg Economics.

Goldman Sachs predicts that foreign inflows will persist as long as high inflation expectations delay rate cuts. The economists noted that this situation is putting the lira under “significant appreciation pressure, even though the currency is not cheap in real terms.” Selva Bahar Baziki, an economist at Bloomberg Economics, commented, “The lira’s muted second quarter, coupled with interest rate differentials that are likely to widen further in its favor, suggests a relatively stable currency outlook. As such, we expect Turkey’s carry trade inflows to continue to grow in the near term.”

Record Foreign Investment in Lira Bonds

Foreign investors have significantly increased their purchases of lira-denominated Turkish government bonds, marking the largest monthly inflow into the country’s domestic debt on record. As of the week through May 17, overseas investors bought a net $1.3 billion of the debt, extending inflows over the past four weeks to $5.5 billion. This has brought non-residents’ holdings of domestic debt to the highest level since February 2021.

The central bank's larger-than-expected interest-rate hike in March and a policy shift towards more market-friendly economic management have bolstered foreign investor confidence. Bank of America strategists have recommended buying lira forwards, citing high carry, positive current account seasonality, and tight monetary conditions. “We are long TRY due to high carry, positive current account seasonality and tight monetary conditions,” they wrote. Citigroup Inc. also noted that Turkish markets are on the verge of a “Renaissance moment,” with analysts including Luis Costa stating that the performance of the lira and bonds will largely depend on the central bank's success in re-anchoring inflation expectations.

Street Views

• Clemens Grafe and Basak Edizgil, Goldman Sachs (Neutral on Turkish central bank's FX strategy):

  "The problem facing the Turkish central bank has moved from FX weakness to the difficulty of avoiding a nominal appreciation amid rising foreign inflows and a more favorable current account seasonality and of sterilizing its FX purchases."

• Selva Bahar Baziki, Bloomberg Economics (Cautiously Optimistic on Turkey’s currency outlook):

  "The lira’s muted second quarter, coupled with interest rate differentials that are likely to widen further in its favor, suggests a relatively stable currency outlook. As such, we expect Turkey’s carry trade inflows to continue to grow in the near term."

• Erik Meyersson, SEB AB (Bearish on long-term sustainability of controlled lira):

  "A controlled lira creates distortionary incentives for higher imports. Coupled with the relatively limited central bank reserves, this approach may not be sustainable in the long term."

Management Quotes

• Fatih Karahan, Governor of Central Bank:

  "Monetary policy would have to be tight until inflation expectations fall."