Investors Desert Turkish Currency in Droves

The Turkish central bank has just gotten a harsh reminder that in currency management, you have to be careful of what you wish for.

In the first half of 2011, the Turkish bank adopted some unorthodox policies aimed at keeping so-called “hot money” from flowing into Turkey and driving up the value of the Turkish lira. It worked, though perhaps too well.

“They went from a problem of far too much credit availability to the other way around extremely fast,” says Jane Foley, senior currency strategist at Rabobank International in London. As a result, the lira dropped 18 percent against the dollar and more than 20 percent against the euro, making it the worst performing currency in the emerging markets last year.

Now, the central bank is charting a course for making the lira stronger. But will the foreign currency markets go along?

They have achieved some initial success. After reaching a low of 1.89 to the U.S. currency earlier this month, the lira has bounced back to around 1.85 to the dollar. The bank said it had spent $4.5 billion in December to stop the lira’s slide, leaving foreign currency reserves at $78 billion.

One reason for the lira’s poor showing was terrible inflation, as data that came out the week before last showed. The inflation rate rose to an annual 10.5 percent in December — the highest level in three years — from 9.5 percent the previous month. Central bank Governor Erdem Basci had promised to bring it down to 5.5 percent by year-end.

The government has refused to raise interest rates to help bring inflation down, which has caused foreign exchange markets to doubt that the government would back the lira. “We have high inflation again and there is lack of confidence in the Turkish government’s efforts to control it,” said Ilan Solot, emerging markets strategist at Brown Brothers Harriman (BBH) in London.

Prime Minister Recep Tayyip Erdogan lashed out at private lenders last Tuesday, claiming they were helping drive up interest rates. “We will make the necessary sharp responses against the interest rate lobby,” Erdogan said.

In addition to inflation, the country recorded a $78.6 billion current account deficit for the year ending in October. That was about 10 percent of GDP.

“The current account deficit was an extreme problem because is has to be funded by international savers, and if they don’t want to go on funding it for any reason, then you can see a very strong depreciation of the currency,” Foley says.

Solot believes the lira will continue to weaken at least until April, when he is forecasting a decline in the inflation rate. But it could rise in the short term, he says.

The central bank’s Basci told Turkish executives this week that because the bank can use dollar sales from its reserves on a moment’s notice, the lira could strengthen “as you sip your coffee.”

For the time being, BBH’s Solot is recommending a relative value trade, such as going long the lira and short the Hungarian forint, because the Hungarian currency has even weaker fundamentals than the lira.

For dollar-based investors, however, Solot recommends staying on the sidelines.