Lira Falls as Erdogan suffers blow in Turkey's municipal ballot

The Turkish lira fell after President Recep Tayyip Erdogan’s ruling party looked set to lose control of key cities in a vote on Sunday, fueling concern that authorities will trigger further currency weakness by doubling down on populist policies.

The currency dropped more than 1% in the Asia session, before trimming some of its losses to 0.2$ at 5.5839 per dollar as of 7:52 in Istanbul.

Early results showed the opposition winning the capital Ankara and taking control of Mediterranean coastal cities from Erdogan’s alliance. While an ally of the president claimed the race in Istanbul, the opposition candidate said the result was manipulated and the party’s leader also declared victory.

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In a short address before departing for a victory speech in Ankara, Erdogan said Turkey has an “important reform agenda” ahead and conceded that some municipalities may have been lost to the opposition.

“Erdogan’s comments on the reform process and free market principles were market friendly,” said Inan Demir, an economist at Nomura International in London. “But if the AK Party loses Istanbul, or wins but the opposition contests the official results, the markets might price in more populism by the government, which would be negative for lira assets.”

Runaway Inflation

Turkey’s currency crash in August drove inflation beyond 20%, battered foreign-currency borrowers, and pushed the economy into its first recession since the global financial crisis as banks lost their appetite to lend.

The central bank has signaled it will maintain a hawkish stance until the pace of price growth slows, but investors are worried that the government will now pursue a more expansionary policy that could stoke an inflation rate running at four times the official target. Before Sunday’s vote, state lenders were already under pressure to prime the economy with cheap loans, while a series of tax cuts designed to boost consumer demand have put a hole in the budget.

After the central bank’s decision to raise interest rates in September initially anchored the lira with the highest carry-trade returns in emerging markets, the currency has weakened more than 5% over the past three months, the most among peers after the Argentine peso.

Dollar Demand

Persistent demand for hard currency from local investors has increased the weakness as they sought protection from inflation and a hedge against any turbulence following the elections. Households and companies have added around $28bn to their foreign-currency deposits over the past six months, taking the total to a record.

Data earlier this month showed the central bank’s net reserves dropped unexpectedly in March, adding to speculation that it was using the cash to support the currency. JPMorgan Chase said the drawdown was unsustainable and recommended investors sell the lira.

Still, the currency’s swings may prove less wild than in crises past. Authorities orchestrated a liquidity crunch last week to stand in the way of short sellers looking to drive the currency lower, which may limit scope for big moves.

Traders were “stunned by the extent of recent measures used to keep the lira stable at all costs,” said Piotr Matys, a strategist at Rabobank in London.

“Market participants will be looking for the Erdogan administration to reveal a comprehensive package of reforms in the coming weeks if not even days to restore shattered confidence,” he said.