Turkey Crisis Deepens

Desperate measures are in the air in Turkey: trading rooms are awash with talk of a bailout by the International Monetary Fund and potential capital controls. But there’s a vacuum at the core.

The central bank and government have been largely silent as the currency plummeted to record lows and the US has imposed sanctions and threatened even more, news outlets reported.

The lira weakened on Tuesday, closing in on a record low hit the previous day as investors' concerns deepened about a rift between Turkey and United States and President Recep Tayyip Erdogan's influence over the central bank.

On Monday, the currency fell as much as 5.5% to 5.425 against the dollar, an all-time low and its biggest intraday drop in nearly a decade, after Washington said it was reviewing access for Turkey's exports to the US market.

The depth of the sell-off reflects growing unease about the direction of monetary policy under Erdogan, a self-described "enemy of interest rates", and the fallout from worsening ties with the United States, a NATO ally and major trading partner, Reuters said.

Lira's Chronic Weakness

The lira's chronic weakness—it is down some 27% so far this year—has driven inflation to nearly 16% and fuelled expectations that the central bank may need to step in with another emergency rate hike, as it did in May, to put a floor under the currency.

"The plunge in the currency over the past few weeks is now on a scale which has, in the past, prompted the central bank to hike interest rates aggressively," William Jackson of Capital Economics said in a note to clients.

"The lira's fall is being amplified by concerns that the central bank will not act to shore up the currency."

The lira was at 5.312 to the dollar at 1029 GMT Tuesday. Against the euro it was at 6.150. It is down some 26% against the common currency this year.

Turkey's 10-year benchmark bond yields hit 20.09%, their highest on record.

“It will remain like this until the central bank commits unconditionally to hike rates and keep them high until inflation has turned,” Henrik Gullberg, a strategist at Nomura International Plc, said by email. “The market needs that sort of hard commitment,” Bloomberg reported.

Yet the radio silence from Ankara—a result of June elections that gave Erdogan almost absolute power in policy making—is deafening. Erdogan is a staunch critic of higher rates and investors worry that he may be standing in the way of any further rate increases.

Turkey’s energy inflation is also expected to continue on an upward trend in the short term due to the outlook for natural gas and electricity prices, Turkey’s central bank said in its monthly statement on price developments on Monday.

Policy Shock?

“It is very difficult to foresee an about-face by the authorities,” said Per Hammarlund, chief emerging-market strategist at SEB in Stockholm. “The moment when Turkey will be forced to go to the IMF for support is drawing closer.”

Although investors are pushing for a significant rate increase from the central bank, there is growing consensus it is going to take lot more than monetary policy to reverse the tide.

“It’s going to be a shock of one type or another: either a policy shock or a macro shock or some combination of the two,” said Christopher Granville, managing director for EMEA and global political research at TS Lombard in London.

Sugar Pill

On Monday the central bank boosted banks’ access to dollar liquidity by $2.2 billion, an effort to take some pressure off the lira. The currency trimmed its losses briefly, only to plunge to successive record lows through the night as investors saw the move as evidence that the bank’s hands were tied.

The lira’s meltdown is not only hurting consumers’ sentiment and wallets, but it’s pushing corporate balance sheets closer to the abyss. Companies that borrowed heavily in foreign currencies now face a growing burden due to the tanking lira.

Companies sit on $337 billion of foreign-exchange liabilities, with a shortfall of $217.3 billion net against assets, according to central bank data. Bank borrowing costs are also rising ahead of more than $100 billion in debt payments coming due over the course of a year.

Capital controls have “become more than a tail-risk scenario now as the authorities show no signs of reverting to more orthodox policies,” said Shamaila Khan, AllianceBernstein’s director of emerging-market debt in New York. But what the lira really needs is “independence of the central bank, tighter fiscal policies and an IMF program.”