(Bloomberg) -- When Wall Street banks and hedge funds gathered in Istanbul last Wednesday with a top Turkish economist, they were prepared to hear about the country’s improved stability. Then they glanced at their phones.
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The Turkish lira was plunging against the US dollar, fueled by that morning’s detention of Istanbul mayor Ekrem Imamoglu — the biggest rival of President Recep Tayyip Erdogan. The group, assembled by Deutsche Bank AG and including clients such as Millennium Partners and Gramercy Funds Management, were shocked and couldn’t take their eyes off their screens, people familiar with the matter said.
While the economist kept going with the presentation, the guests kept waiting for the country’s state-run lenders to start selling more dollars — the Central Bank of Turkey’s typical method for supporting the lira. But that didn’t happen.
Within about half an hour, investors around the world had dumped huge volumes of lira, slashing its value by 10% to a record low. A market participant at one of the biggest Wall Street banks estimated that about $5 billion worth of the currency had changed hands by 9 a.m. in London, about ten times the morning average. Another suggested total outflows over the day neared $10 billion.
The turmoil soon spilled over into the broader markets, with a gauge of Turkish banking stocks dropping by the biggest amount since 2013 and 10-year government bond yields topping 33%.
Last week was a blow to Turkey’s finance officials, who’d spent the last two years trying to bolster economic calm, persuading Wall Street investors to look past previous eras of instability and wager on the country’s currency and sovereign debt.
But after that chaotic half an hour, much of that work had been erased.
“Once you have a move of that magnitude, it takes time to regain confidence,” said Brad Bechtel, head of foreign exchange at Jefferies Financial Group Inc. in New York. “It’s going to come down to how the central bank responds and whether Erdogan tries to control it. That would be bad news and hopefully that will be avoided.”
Spokespeople for Deutsche Bank and Millennium declined to comment on the meeting. A spokesperson for Gramercy also declined to comment on the gathering, but said in an emailed statement “it is accustomed to managing political and market shifts and wasn’t unnerved by the recent events.”
‘The Final Straw’
Following the formal arrest of Imamoglu over the weekend, Turkish markets began this week once again on edge with the lira resuming its fall.
Hundreds of thousands of Turks protested Imamoglu’s detention over the weekend, defying bans handed down from the governors of Istanbul, Ankara and Izmir. Erdogan has responded by warning the main opposition — the Republican People’s Party, or CHP — that such demonstrations would not be tolerated.
Investors had expected the lira to fall if Imamoglu was detained, the people said. Few are more popular than the 54-year-old, who was set to be named the CHP’s candidate for presidential elections on Sunday. Turkey’s next presidential election is due in 2028, though under the constitution Erdogan, 71, is barred from running again.
The currency had already slid in recent weeks as Turkish authorities widened a crackdown on opposition figures and tension was building.
“He’s so visible and so prominent in the political scene and clearly one of the favorites to beat” Erdogan, said Bechtel. “It was sort of the final straw.”
Yet what blindsided them was the sudden nature of the drop, the people said.
Shocking Speed
For years, hedge funds and other institutional investors had been led to believe that if there ever was a crisis brewing in Turkey, there were enough dollar reserves in the country that local banks could sell to prevent a nosedive in the lira.
That’s what traders were waiting for Wednesday morning.
But Turkey’s state-run banks had already exhausted their daily credit limits with offshore lenders — leaving the lira vulnerable for that fateful half hour, the people said.
Hedge funds spurred the selling, swapping their lira for dollars in increasing volumes from 7 a.m. onwards in London, the people said. One employee at an emerging-markets hedge fund in the UK capital, who requested anonymity, boarded an underground train at about that time, when the exchange rate valued a single dollar at just over 36 liras. When he came back above ground, the rate had surged to above 40 liras.
Stark Turnaround
The selloff was a stark turnaround from the past two years.
Wall Street banks, hedge funds and other asset managers had grown to avoid Turkey after years of instability spurred by the country’s unorthodox economic policies and bouts of political turmoil. Yet, lured by Finance Minister Mehmet Simsek and his focus on fighting inflation and keeping the lira stable with high interest rates, foreign investors had gradually returned, snapping up about $30 billion of Turkish stocks and bonds since 2023, data show.
In particular, investors had flocked to a transaction known as the carry trade, which has them borrow in currencies with low interest rates and then invest in higher-yielding assets in another currency. The strategy pays off as long as the second currency doesn’t start tumbling. The trade returned more than 30% for the Turkish lira last year — one of the best of its kind in the world.
These kinds of profits spurred investors to visit Turkey more frequently. Greg Coffey, founder of the hedge fund Kirkoswald Asset Management, held meetings with bankers and economists in the country in September to test investment ideas, Bloomberg reported at the time.
The carry trade had surged to more than $30 billion in size before Wednesday’s selloff, according to analysts at JPMorgan Chase & Co. Outflows from the transaction were more than $10 billion that day, which likely amounted to hundreds of millions of dollars of losses for investors, some of the people said.
The carry trade appeared “stable on the surface” but it came with high risk, said Carlos de Sousa, a portfolio manager in emerging-market debt at Vontobel Asset Management
“Anyone participating in a high double-digit carry trade should be prepared for volatility,” said de Sousa. “High carry is always a reflection of high risk, never a free lunch.”
Stability Watch
Some investors view this week’s selloff as a blip. As long as Erdogan continues to support Simsek’s team and their more orthodox approach to Turkey’s economy, stability will persist.
“We view the current situation in Turkey as a temporary setback,” said Anders Faergemann, co-head of emerging-markets global fixed income at Pinebridge Investments. “It has taken time to rebuild the trust with investors and it would be too costly to allow a few political missteps to unwind it all.”
Others aren’t so sure.
“There’s definitely a short-term impact,” said Kit Juckes, head of FX strategy at Societe Generale SA in Paris. “This was a very popular trade. People got caught very much by surprise and won’t go back in a hurry.”
(Updates with further comment from Gramercy in ninth paragraph.)
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