The Lira and the Dollar

What a ride we had — from the ocean of liquidity to the desert of uncertainty, as the unwinding of the credit cycle has undermined confidence and led to the sudden withdrawal of market liquidity. Aftershocks of the financial turmoil eased in recent days, but there is still a dichotomy in markets about the future direction of the global economy. For the time being, real economic fundamentals stand strong against a hard-landing scenario. However, even though we have no doubt about structural improvements (especially in emerging economies), the global economy is vulnerable to financial turbulence and a major downturn in the US business cycle. After all, expansionary financial conditions in the last six years had an overwhelming effect on economic activity across the world. Therefore, even if we assume the resilience of structural gains, tighter financial conditions would still have an adverse effect on the real economy. Furthermore, a broader repricing of risks implies a possible contraction in cross-border capital movements that could put pressure on emerging market currencies. In Turkey’s case, for example, the exposure to liquidity-driven capital flows represents the most critical vulnerability.



Nevertheless, having such a ‘weak spot’ does not necessarily mean that there are no cushions to safeguard the economy against exogenous changes in global risk appetite. First, economic fundamentals are now far stronger than at any other time in recent history. Second, the banking sector is robust and liquid enough to provide funding to the troubled European banks. Third, residents accumulated more than US$30 billion in foreign currency-denominated deposits over the last year, which now stands at US$90 billion against foreign investors’ US$32 billion in domestic government debt.




The lira has already depreciated by more than 5% against the dollar in the last couple of days, with a sharp increase in its degree of volatility. Despite all the fundamental improvements in the economy, Turkey remains susceptible to the unwinding of carry trades because of its significant exposure to liquidity-driven capital flows. Foreign investors own about 45 billion lira worth of domestic debt, accounting for 38.1% of non-bank holdings in the country (up from 32.7% at the end of 2006 and 20.7% last summer). The extent of international portfolio investments is not limited to the fixed income market, as foreign investors also hold 72% of free float in the equity market (see The Istan-Bull Paradox, June 13, 2007). Therefore, it would not be surprising to see a global liquidity squeeze and a possible increase in home bias leading to abrupt portfolio and exchange rate adjustments. Given the sensitivity of consumer price inflation to currency fluctuations and changes in inflation expectations, we have no doubt that the deepening of liquidity concerns will affect the timing and magnitude of interest rate reductions.

Yesterday the Hungarian forint snapped a four- day rally against the euro as a decline in global stocks crimped demand for riskier, emerging-market assets. The forint fell from a two-week high as the NTX Index of stocks in central and eastern Europe's 30 biggest companies slipped for the first day in a week. Poland's zloty, Turkey's lira and the Romanian leu all dropped.


Against the euro, the forint fell to 257.68 by 4:42 p.m. in Budapest, from 256.15 late Tuesday.

The Turkish lira fell to 1.3292 per dollar, from 1.3185 Monday, when it touched a two-week high. Turkey's Foreign Minister Abdullah Gul won a parliamentary election to become the country's president today.

The Polish zloty slid 0.1 percent from near a week-high to 3.8305 per euro, while Romania's leu traded at 3.2527 versus the common European currency, from 3.2446.

The Czech koruna rose to 27.681 per euro, from 27.771 yesterday. Investors borrow the koruna at its relatively low 3 percent interest rate to fund higher-yielding purchases elsewhere in the so-called carry trade, so the currency tends to strengthen when they pare riskier investments.

The Slovak koruna was little changed at 33.766 against the euro after the Bratislava-based central bank kept its two-week repurchase rate at 4.25 percent, as forecast by economists surveyed by Bloomberg News.

On Monday

Turkey's lira rose to a two-week high against the dollar as an advance in Asian and European stock markets stoked investor appetite for higher-yielding assets.

The lira added to last week's advance, its best performance in more than a year, as investors bought the currency by borrowing the Japanese yen or Swiss franc more cheaply. The NTX Index of stocks in central and eastern Europe's 30 biggest companies advanced for a fourth day while Istanbul's ISE National 100 index rose the most in almost a week.

``The Turkish lira is mainly driven by risk sentiment,'' said Elisabeth Andreew, chief currency strategist at Nordea Bank AB in Copenhagen.

Against the dollar, the lira gained as much as 1.6 percent to the highest since Aug. 14, and traded at 1.3180 by 4:12 p.m. in Istanbul, from 1.3327 at the end of last week. The currency also rose versus the euro, to 1.7993 from 1.8166 on Aug. 24.

Turkey's government bonds rose, according to an ABN Amro NV index of debt yields.

So-called carry trade investors buy lira-denominated assets because of Turkey's 17.5 percent interest rate, the highest in Europe.