The carry trade with the Turkish lira has proven the most profitable across emerging markets in the past six months, thanks to high interest rates and a shift towards orthodox economic policy. Investors have seen promising returns from borrowing in U.S. dollars and investing in the Turkish lira, with the potential for further gains if it maintains policy continuity and reduces inflation.
Daniel Wood, a portfolio manager at William Blair International, says the country's run is just beginning. "If Turkey is successful in bringing inflation down meaningfully, then we are much closer to the beginning than the end of the lira having strong carry appeal for international investors," Wood continued. "The most important factor in driving the value of this trade is policy continuity."
Since the beginning of the year, Turkiye's high returns have not protected its lira, which has depreciated by 8.3% against the dollar. However, this downward trend has slowed since the central bank implemented a significant interest rate hike in March. There are indications that the Turkish government may be considering easing restrictions on offshore currency swaps. These restrictions were originally imposed to prevent shorting of the currency, but they have deterred foreign investors who cannot hedge against lira losses. If these restrictions are relaxed, and with the central bank's reassurances, this change will likely boost investor confidence.
Hedge funds and other traders have plowed billions of dollars into the Turkish lira in recent months, chasing the high returns paid by Turkiye on interest rates of 50%, with $24 billion flowing into such trades since October alone. Such a surge in "fast money" has exposed the country to a sudden turn in investor sentiment, but it has also dramatically boosted the central bank's foreign currency reserves.
Following the removal of President Recep Tayyip Erdoğan's son-in-law as finance minister last summer, there has been a shift back to traditional economic policies. Consequently, international fund managers, who had previously left the market due to unorthodox measures that led to uncontrollable inflation, are returning. A June survey of JPMorgan clients revealed that investors hold a larger position in the Turkish lira compared to the benchmark index weighting, for the first time in five years.
Despite the rapid flow of money, conservative investors remain cautious; pension funds and significant foreign direct investments in real projects, such as factories, are still wary of policy reversals. The effort to deliver a more predictable economic environment from the finance ministry will pay dividends at some stage. Foreign investors have pumped about $12.5 billion into lira-denominated government bonds since the policy change.
Finance ministry data shows that foreign ownership of Turkiye's domestic debt stock climbed to 6.7% from 0.6% before the May 2023 election. Such foreign investment has proven instrumental in helping rebuild the central bank's foreign currency reserves, which have jumped to $40 billion from around minus $20 billion last summer.
Turkish households remain unconvinced, foreseeing rising inflation and grappling with higher borrowing costs. Annual inflation accelerated by nearly 76% in May. The central bank, however, projects a sharp deceleration by the end of the year; since the beginning of 2022, food prices have risen more than 50% over the previous year, and this news has fueled public alarm. The success of the Turkish lira as the emerging markets carry trade will depend on whether orthodox economic policies continue and how they will keep inflation under control. Returns are fairly high, and foreign investments are rising; however, fast money inflows can bring volatility and domestic economic challenges.
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