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Guldem Atabay
Mar 27 2019

Turkish swap market storm highlights misspent efforts to cap rates

A surge in Turkish swap rates on international markets has been caused by the government’s unorthodox attempts to both reduce interest rates and control the level of the lira.

Such efforts to simultaneously lower rates and strengthen the currency are currently at odds with liberal economics, which requires an unhindered flow of capital in and out of the country, and free-market supply and demand for Turkish assets.

These unfruitful efforts, which began at the start of the year, have brought the London swap market overnight interest rate to around 600 percent as of early on Wednesday.  Low trading volume has partly played a role in the spike, though the main culprit is again the government's efforts to control the level of the lira, in this case limiting it to around 5.5 to 5.6 per dollar. These abnormal steps will soon backfire.

A swap is a form of trading in currencies; in this case the dollar and the lira.

The Central Bank of Turkey on Friday halted lira funding through weekly repo auctions at its benchmark rate of 24 percent to create demand for the lira. Yet, demand for hard currency continues and Turkish banks and their London-based counterparts have been making deals among themselves in what is known as "over the counter" operations.

The central bank's current absence from the swaps market and now that of Turkish banks – traders say institutions have been told by the authorities in Ankara to refrain from participating - creates a cash shortage which has carried the cost of borrowing to the current astronomical levels.

Thus, the central bank's indirect approach to raise and control borrowing costs is proving to be ineffective as investors are demanding a far higher lira interest rate when it comes to the swaps market.

Troubles in swaps are now translating into higher borrowing costs for the government, exactly the opposite of what the government has been trying to achieve. Banks are selling Treasury bonds in order to boost their lira liquidity. The central bank’s restrictive measures are also causing foreign investors to shy away. Consequently, yields on benchmark 10-year lira debt rose to more than 18 percent on Wednesday, the highest level since October, from 16 percent last week.

The government has spent the last few months trying to bring borrowing costs in lira down by restricting debt sales and selling bonds in uncompetitive auctions to state-owned institutions. Those efforts now appear to be coming to nothing.

Back in the swaps market, a Turkish bank is now forced to pay very high rates to cover the need for short-term foreign exchange through such transactions, which creates a liquidity shortage because they have now been told to stay away. In an effort to honour existing positions, banks in Turkey would either have to sell Treasury bonds or bear very high interest rates for the liquidity the swaps bring.

Although such dynamics appear temporary, it encourages more investors to flee the Turkish lira. After a two-day rally following losses of more than 4 percent on Friday, the lira was trading 1.6 percent lower at 5.41 per dollar in Istanbul on Wednesday.

While it is rumoured that state banks and institutions are buying the lira to support its value, the government should refrain from efforts to cap losses, given that a very tight external debt repayment schedule is bolstering demand for hard currency. That includes punishing foreign banks unjustly for manipulating the lira. Regulators started an investigation of JPMorgan at the weekend on such charges after the U.S. investment bank produced a research report recommending clients sell the currency.

The market, hindered by government policy, is like a pressure cooker with demand boiling away. Once the lid is off, the danger is that demand could explode. Then the lira is in danger of sliding nearer to the record lows seen last year, interest rates would jump further and Turkey’s recession-hit economy would incur more damage both in the short and medium term. 

The opinions expressed in this column are those of the author and do not necessarily reflect those of Ahval.