New Bond Regulations by the Turkish Central Bank Establish the State’s Dominance in the Market

The Turkish central bank has implemented a new requirement for banks to hold securities against foreign exchange deposits, which has resulted in a significant decrease in bond yields and positioned the state as the dominant player in the debt market, according to analysts. This move is one of several that have been implemented to utilize banks and bond markets to combat inflation and stabilize the country’s sliding currency, reinforcing President Tayyip Erdogan’s commitment to low interest rates. Since the announcement, the 10-year benchmark bond yield has fallen by nearly 700 basis points, signaling a significant decrease in the Treasury’s long-term borrowing costs, but it also leaves banks assuming the risks.

In recent years, banks in Turkey have preferred floating-rate bonds such as those linked to the consumer price index (CPI) over fixed-income debt in their Treasury borrowing due to rising inflation and the country’s easy monetary policy. However, non-fixed coupon bonds such as CPI-linked ones cannot be held for foreign currency under last week’s regulation. Banks are now required to purchase long-term fixed-rate bonds and take on the inflation risk, which is a risky practice and another example of suppressing symptoms rather than providing a long-term solution, says Hakan Kara, a Bilkent University faculty member and former chief economist at the central bank.

Turkey’s annual inflation rate hit a 24-year high of 73.55% in May, and the lira has dropped by 24% against the dollar this year, following a 44% slump in 2021 due to unconventional rate cuts sought by Erdogan, who is trying to boost growth ahead of mid-2023 elections. The central bank has stated that fixed-rate government bonds with a maturity of at least five years and four years remaining to maturity will be accepted as securities in return for foreign currency deposits. Banks are required to hold lira fixed-rate bonds equivalent to 3-10% of their foreign currency deposits by the end of June, with the specific requirement depending on their ability to convert foreign currency to lira.

According to Burcu Aydin Ozudogru, a former revenue policies general manager at the Treasury and a Bilkent University faculty member, although the measure will alleviate the Treasury’s long-term borrowing expenses, it will also elevate the exchange rate and pose a risk of maturity differences on banks’ balance sheets. A senior banker has described the regulation as a plan to force banks to purchase fixed-rate government bonds. As of June 3, official data shows that there were $238 billion of forex deposits in the Turkish banking system, and separate data shows that foreign investors financed 1.7% of the Treasury’s lira-denominated domestic borrowing at the end of April, down from approximately 25% six years ago.

In conclusion, the Turkish central bank’s new requirement for banks to hold securities against foreign exchange deposits has had a significant impact on the country’s debt market. While it will ease the Treasury’s long-term borrowing costs, it will increase the exchange rate and the risk of maturity differences on bank balance sheets. The move also positions the state as the dominant player in the debt market, and banks are left bearing the risks. Turkey’s high inflation and sliding currency remain significant challenges, and it remains to be seen how effective these measures will be in addressing them.