Turkish Central Bank Governor Erdem Basci said on Tuesday he did not intend to hike interest rates to defend a sliding lira, which hit record lows on concern about the outlook for U.S. stimulus and the conflict in neighbouring Syria.
In an interview with the state-run Anadolu news agency (AA), Basci said the central bank had $40 billion in reserves which it could use to shore up the lira and would intervene defensively as needed to reduce exchange rate volatility.
The lira weakened to a record low of 2.037 to the dollar as markets wondered whether the bank had the firepower necessary to defend the currency.
The main Turkish share index slid 4.7 percent to close at its lowest in a year.
The 10-year benchmark bond yield spiked to 10.83 percent during Basci's interview, which was broadcast live on Turkish financial TV stations, from 10.18 percent on Monday. It closed at 10.28 percent.
"We will not be using our interest rate weapon against the exchange rate. We are very clear on that and we have said there will not be any uncertainty about interest rates," Basci told AA Finans (www.aafinans.com).
"Since we will not be using this then we are left with the balance sheet weapon, and that is a very powerful weapon. That means we will use our foreign exchange reserves against the slide in the foreign exchange market."
His comments surprised many economists.
"Turkey's central bank is digging itself into a deeper hole. For a country whose forex reserves barely cover its short-term external debts, this is highly imprudent policymaking," said Nicholas Spiro of Spiro Sovereign Strategy.
Emerging markets have borne the brunt of heavy selling in recent weeks amid concern that the U.S. Federal Reserve will soon start reducing its massive bond-buying programme, which had flooded developing economies with cheap liquidity.
Turkey is particularly vulnerable because it is heavily dependent on foreign inflows to finance its current account deficit, running at over 7 percent of national output.
Concern about the consequences of a possible U.S.-led intervention in neighbouring Syria and political uncertainty ahead of an election cycle beginning next year have further dampened its appeal as investors shun riskier assets.
Basci said he was not overly worried about the exchange rate, forecasting it would recover by the end of the year to around 1.92 to the dollar, and that long-term bond yields would also be back in single digits.
"Don't expect a shock from us on the interest rate side, just expect interesting manoeuvres on the forex side that will result in an appreciation of the lira," Basci said, in characteristically cryptic comments.
"I am neither a hawk nor a dove," he said when questioned about his policy stance. "I am not a bird."
Weak lira takes toll
The central bank raised its overnight lending rate, the upper end of the interest rate corridor it uses to control monetary conditions, for a second straight month last week, hiking it by 50 basis points to 7.75 percent in a surprise move to try to prevent an uncontrolled slide in the lira.
Basci said the average cost of lira funding would remain between 6.75 percent, the rate at which it funds primary dealers, and 7.75 percent until inflation drops to its year-end forecast of 6.2 percent.
"The central bank is once again demonstrating it is unwilling to raise rates much further, and that will continue to drag (the dollar/lira rate) higher," Luis Costa, head of CEEMEA currency and debt strategy at Citi, referring to more lira weakening.
Economy Minister Zafer Caglayan, a vocal supporter of low interest rates and champion of Turkish exporters, who benefit from a weak lira, said the central bank did not need to intervene to support the currency, saying the 2 to the dollar level it breached on Tuesday was only a psychological barrier.
He also dismissed suggestions that any Turkish participation in an international coalition to intervene in Syria would have a negative impact on the economy.
But the effects of the weak lira - which has fallen 14 percent against the dollar from a peak this year of 1.7455 on Feb. 1 - are already being felt by some of Turkey's top firms.
A weak lira cut net profit at national flag carrier Turkish Airlines by almost a third in the second quarter despite a sharp rise in sales, sending its shares tumbling more than 2 percent on Tuesday.
The country's largest telecoms group Turk Telekom , whose liabilities are in dollars, euros and Japanese yen, said last month its net profit fall 56 percent in the same period due to foreign exchange losses.
The weakening lira and Basci's comments helped knock the main Istanbul share index down by more than 3 percent to a year low although it later recovered somewhat to trade down 2.4 percent by 1030 GMT.
"Combined with the uncertainty over a multi-party military intervention in Syria, the comments are negative for Turkey's financial markets," said Ibrahim Aksoy, economist at Istanbul-based Seker Securities.