ISTANBUL Turkey has upped the ante in defence of the lira, but with hard cash reserves far smaller than those of many developing economy peers, FX intervention may not be feasible for long should investors resume their exodus from emerging markets.
Faced with year-to-date lira losses of almost 20 percent to the dollar and rising inflation, the central bank this week mounted its most aggressive defence of the currency yet, selling a record $1.1 billion (715,000 pounds) on Wednesday and Thursday and making changes to banks' reserve requirements.
The action succeeded in lifting the lira well off record lows. But any further FX interventions will put Turkey in serious danger of depleting a reserve stash that is its primary buffer against a large balance of payments deficit.
Reserves stand now at around $85 billion, far short of the hundreds of billions of dollars held by other comparable emerging market countries and down more than 10 percent from July as a result of the central bank's daily dollar auctions.
"This speed of reserve drawdown is not sustainable," said Manik Narain, emerging markets strategist at UBS in London. "Turkey's reserves in terms of external debt coverage or import coverage are among the lowest in emerging markets."
In contrast, South Korean interventions throughout September cost it $9 billion but made a dent of less than 3 percent in its reserves, the world's eighth-largest.
Central bank data shows $132 billion in external debt payments due in the coming year, mostly private sector. Add in the huge current account gap and the liability mounts to over $200 billion -- more than double its current reserve level.
Turkey in fact is one of only four emerging countries whose FX reserves are insufficient to cover annual trade balance needs and maturing short-term debt, a UBS study shows. The other countries in this position are Bulgaria, Latvia and Belarus.
"The Turkish central bank ... is not Brazil or Korea which have a lot more firepower," said Alia Yousuf, a bond portfolio manager with ACPI Investments in London.
"If this (reserves decline) continues it will obviously lead to more uneasiness with investors. Ultimately if global market uncertainty remains, funding the Turkish current account deficit will become an increasing worry."
BNP Paribas analysts note that the gross reserves-imports ratio stands at 37 percent while the reserves to short-term debt ratio is at 98 percent, just above levels it says are mentioned by the bank in its reserve management guidelines.
"Our back-of-the envelope calculation yields that if the central bank sells $10 billion more, all FX reserve ratios will decline to or below their critical levels," BNP told clients.
Though the central bank deliberately engineered a depreciation in the lira in the early part of the year, it has appeared increasingly uncomfortable with the scale and pace of the currency's fall.
On Thursday it attempted to soothe analysts' worries, saying in a presentation that its reserve position was quite strong, judging by the ratio of reserves to short term FX debt.
But signs are it is uneasy; hence the decision to allow banks to hold more reserves in dollars, a step that may add $3.6 billion to its own coffers.
But the coming months may well see a further rise in dollar demand from Turkish banks and corporates which borrowed heavily overseas to fund booming domestic growth but will see a record $132 billion come due in the coming year, including coupons.
RBS compared the predicament to Russia's in 2008, when a third of FX reserves vanished in the rouble's defence.
"Russia suffered badly back then because it had $160-80 billion in external debt liabilities falling due; and yet it got into trouble even with $590 billion in FX reserves, which now underscores the risks in Turkey's case," RBS said.
RESERVES OR RATES
So apart from praying for a quick resolution of the euro zone crisis, what can Turkey's central bank do next?
Tufan Comert, strategist at Garanti Securities in Istanbul said the central bank could try for a swap line with the U.S. Federal Reserve, which stepped in to provide liquidity to many emerging central banks in 2008. Or it could lend dollars to banks on forex deposit instead of selling, he said.
What markets would really like to see is an interest rate rise. Turkey's policy rate, the one-week repo rate, is at 5.75 percent, a negative rate in real terms, though the one-year bond yield is still in positive territory at 8.3 percent.
Yet the central bank admitted this week end-2011 inflation would be significantly above-target.
But a rate rise would mark an immense U-turn for the bank which has eased policy several times this year to engineer lira depreciation. It would argue a rate hike now will put Turkey at a disadvantage, given growth at home and abroad is slowing.
"I would have liked to have seen the central bank defending the lira with interest rate weapons as well, rather than only intervention," said Namik Aksel, chief executive of HSBC Asset Management Turkey. "Obviously this policy is a risk but they do have a point. Growth is going to be the main driver in 2012."
He too reckons no more than $5-$10 billion can be spent from now in the lira's defence. After that circumstances may force the central bank's hand -- the bank's strategy clearly hinges on a reversal of the global bearish market sentiment.
"I do believe they may hike overnight borrowing rates if we see another round of heavy sell-off," Aksel added.
(Editing by Catherine Evans)