The Turkish lira traded around 4.37 at the end of the New York session, a hair’s breadth below its intraday low last week and a lowest-ever daily close. The Turkish central bank should raise interest rates drastically – market chatter mentions a 2% hike – but as the collapsing Argentine peso showed last week, even a drastic increase in interest rates won’t necessarily help.

Turkey is in a trap: Most of its corporate debt is denominated in foreign currencies (roughly equally split between dollar and euro), so the cost of debt service rises as the lira depreciates. A conventional solution would let the lira find its own value; the currency certainly seems overvalued, which is to say that the actual price level has risen much faster than the official inflation data indicated. The trouble is that a free-fall in the currency would lead to a wave of corporate bankruptcies, and corporate bankruptcies would reduce the credit quality of Turkish banks – the same banks that have borrowed a net US$60 billion on the short-term interbank market.

If Turkish banks can’t roll over their interbank positions, Turkey’s foreign exchange reserves of US$83 billion (as of March 31) would be gone in a heartbeat, and the country would have to throw itself upon the mercy of the International Monetary Fund. The likelihood is that further lira depreciation will lead to a severe recession after the credit-fueled boom of 2017.

Asia Unhedged is still a seller of Turkish lira. Turkish stocks have lost 26% of their value on the Istanbul 100 Index since the September 7 peak, and are trading at a forward P/E of just 6.43 – but we advise against trying to catch the falling knife.

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