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Turkey’s monetary tightening faces funding setbacks

Turkey’s central bank increased the inflation forecast for 2023 to 65 percent from its previous estimate of 58 percent Reuters/Cagla Gurdogan
Ankara has abandoned a practice of using reserves to directly support the lira currency

Bankers warned on Wednesday that the effectiveness of recent monetary tightening in Turkey could be negatively impacted after funding conducted through open market operations (Omo) by the central bank turned negative for the first time in over a decade.

The central bank has boosted its reserves by $20 billion since the beginning of June, mostly from exporters’ foreign currency income, leading to 500 billion lira entering the market.

The additional liquidity reduced the banking system’s lira funding needs from the central bank.

The central bank funds the market using swaps with local banks, as well as Omo which include various repo methods.

When lenders deposit the excess lira liquidity they have at the end of the day through the lower band of the central bank’s interest rate corridor at 13.5 percent, the net Omo funding drops below zero.

“The lira becoming so abundant in the system all of a sudden, it could create a risk by increasing forex demand,” said a forex trader.

Turkey’s central bank has reversed years of loose policy after President Tayyip Erdogan appointed Hafize Gaye Erkan, a former Wall Street banker, as governor last month.

The central bank raised its policy rate by 650 basis points in June to 15 percent and is expected to raise it further on Thursday.

It also began building up its reserves after stopping using them to support the lira, which has declined 30 percent this year.

Net international reserves, which touched a historic low of negative $5.7 billion last month, rose to $13.17 billion by July 7. Bankers calculate an increase between $300 million and $500 million in net reserves in the week to July 14, as well as a $2.5 billion rise in total reserves to $113 billion.

Turkey’s central bank provided a net 865 billion lira to the banking system on Wednesday, which included 1.05 trillion lira, or about $39 billion based on the related exchange rate, provided through swaps, placing the funding through repos on the day at a negative 175 billion lira.

That compares to 660 billion lira of swaps and 680 billion lira of repo funding on June 1.

Lenders using the lower band of the interest rate corridor to deposit excess lira liquidity at the central bank was last seen in 2011, said Burumcekci Consulting founder Haluk Burumcekci.

“This situation has brought down deposit rates in recent days and contributes to dollarisation by making investment in (the) lira less attractive,” he said, adding that this makes monetary policy less effective.

While some bankers expect the central bank to take new steps to increase the need for repo funding, such as regarding required reserves, others say the pace of building reserves could slow.

A slowdown in loans has also decreased the market’s need for lira, according to one trader, adding that banks prefer using more “advantageous” swaps instead of repo.

“This process also brings with it a decline in deposit rates,” the person said.

The deposit rates have dropped to below 30 percent, from 40 percent several weeks ago, according to bankers.