Turkey’s central bank has launched currency swap auctions as part of a series of extraordinary measures to try to support the lira.
The lira slumped to record lows against the dollar this year and policy makers have come under pressure from President Recep Tayyip Erdogan to not raise interest rates to avoid hurting economic growth. Instead the central bank pushed up borrowing costs by tightening the supply of liras and this week started swap auctions to manage liquidity.


What are the swap 
auctions?
The monetary authority on Thursday lent banks $300mn at an annual rate of 0.75%, and borrowed liras in return, which it will pay 8.5% interest to hold for a week, before swapping them back.
The combined amount offered over the last two days climbed to $800mn. The central bank increased the interest on liras borrowed to 8.5% from 8% on Wednesday, and left the rate on dollars unchanged.
The central bank said on Tuesday that it was planning on using this new facility to manage lira and foreign exchange liquidity. The measure was also meant to support the lira without depleting the bank’s foreign currency reserves, according to a person with direct knowledge of its plans.


Will the auctions 
support the currency?
The lira leg of the one-week swap on Wednesday was well below market rates, prompting brokers including Morgan Stanley to doubt the efficacy of the move, saying it wasn’t enough to support the currency. The overnight swap rate, as measured by implied yields, currently trades at around 8.66%, up one basis point since Tuesday.
When Turkish banks are in need of foreign currency to finance their activities but don’t have enough on hand, they regularly exchange their liras for dollars in the international swap market. That supply of liras provides ammunition for short sellers, who take the borrower side of the swap trade and sell the liras in the spot market, betting that by the time the swap comes due they’ll be able to pocket the difference.
Only by paying a high enough rate on the lira leg of swap transactions with local lenders would swap market rates in the offshore market move higher to levels that dissuade this practice, Morgan Stanley analysts including James Lord wrote in an e-mailed note.


Will the auctions 
reduce volatility?
The central bank may be less interested in manipulating spot rates directly and more concerned about taming volatility in the foreign exchange market, according to Fatih Keresteci, a strategist at DNG Advisory Services.
“When the news first came out the market thought the central bank was trying to push up short-term swap costs higher and try to support the currency,” Keresteci said by phone. “But the terms of the swap rates show that the central bank has another aim for this operation. By ensuring that foreign exchange liquidity is efficiently distributed, instead of trying to support the exchange rate, it is trying to lower volatility.”
While implied volatility on the lira has dropped 520 basis points to 19.7% on Thursday from a peak of 24.9% on January 11 , it still remains the most volatile emerging market currency tracked by Bloomberg.
Taking measures to meet some of Turkey’s ongoing demand for dollars locally may help tame price swings. Turkish banks are on the line for $21.3bn of loans due in 2017, 40% of which mature in the second quarter, according to data compiled by Bloomberg.
What’s more, a maturity mismatch between foreign currency credits and deposits means lenders often find themselves forced to use FX swaps to finance credit growth. By offering cheap dollars through its swap facility, the central bank is effectively lowering the amount of dollars that banks have to scramble to buy or borrow in the market.


Will the auctions help the dollar shortage?
While the measures may provide some relief and ease uncertainty, swap transactions don’t increase the supply of dollars Turkey has, according to Global Yatirim economist Sertan Kargin. These types of measures are therefore unlikely to serve as a “panacea” for Turkey’s currency woes, he wrote in a note before Wednesday’s auction.
Turkey has a gross external financing need of $200bn and a corporate debt currency mismatch of $213bn, which means the economy is constantly seeking to buy foreign exchange as it meets these payments. This shortfall hangs over financial markets “like a sword of Damocles,” Kargin said.