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Turkey's attempt to stem the lira rout may come back to haunt it

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By squeezing liquidity out of the offshore currency swap market, the Turkish banking regulator forced speculators betting against the lira to close their positions.

[ISTANBUL] While Turkish authorities may have stopped the lira from hemorrhaging, their measures may cost the nation's debt and equity markets.

By squeezing liquidity out of the offshore currency swap market, the banking regulator forced speculators betting against the lira to close their positions. That also made it much harder for foreign investors in local bonds and stocks to hedge their currency risk. Now, it looks like they're bailing.

The yield on five-year local currency bonds jumped more than 250 basis points last week to a fresh record and the benchmark stock index led global losses. That's a sign that stop-gap actions to stem the currency slide had unintended consequences, even as the battered lira staged an impressive recovery.

"The risk is you're throwing the baby out with the bathwater," said Anders Faergemann, a fund manager at PineBridge Investments in London. "If you hold Turkish assets you're now unable to hedge the currency. We saw that in Malaysia last year and it creates uncertainty. If you can, you're probably going to sell your local bonds. We're seeing the same thing in the stock market."

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Foreign investors exchange their dollars and euros with Turkish liras held by local banks through forward agreements to take directional bets on the currency, as well as to hedge their exposure to the country. So when the Banking Regulation and Supervision Agency, or BDDK, capped local lenders' swap and swap-like transactions to just 25 per cent of shareholder equity on Wednesday, liquidity began to dry up, rates surged and many investors had little option but to offload their holdings.

The banking regulator Friday expanded its limits on currency swaps to non-swap derivatives. Turkish banks' purchases of lira forwards, options and other non-swap derivatives cannot exceed 25 percent of banks' legal shareholder equity, BDDK said on its website.

The Turkish lira has effectively become "untradeable," David Riley, chief investment strategist at BlueBay Asset Management LLP, said in an interview on Bloomberg Television.

Turkey's central bank is also tightening liquidity in the local market by forcing lenders to borrow from its more expensive overnight lending-rate window, effectively raising funding costs by 150 basis points over the past week. The monetary authority signed a US$3 billion dollar swap agreement with the central bank of Qatar to help trade between the nations and support financial stability, it said in a statement on its website on Monday.

Yet the lira resumed its decline, trading as much as 2.7 per cent weaker against the dollar, as the prospects of further US sanctions and downgrades by S&P Global Ratings and Moody's Investors Service spurred uneasiness before Turkish markets close for a week-long public holiday.

"Just shows at this stage there are no easy options for Turkish policy makers," said Timothy Ash, a strategist at Bluebay in London. "The obvious solution has always been just raise the base rate and go back to plain and simple vanilla central banking."

BLOOMBERG