Turkey ends lira protection scheme as banks tally up damage

New rules introduced by Turkey’s central bank to wind down a costly deposit scheme designed to support the Turkish lira are likely to push banks to increase their government bond holdings and thus help finance the gaping budget deficit, market watchers say.

According to the central bank, the regulations passed Aug. 20 aim to phase out the so-called FX-protected deposit scheme, which was introduced in December 2021 as an emergency measure to salvage the nosediving lira. Under the scheme, also known by the Turkish acronym KKM, depositors who converted hard-currency accounts to lira deposits are paid compensation by the state for any depreciation that exceeds the interest on the deposits. The central bank now wants banks to gradually encourage KKM depositors to shift to regular lira accounts. Banks that fail to meet ambitious transition targets are required to buy additional low-yield government bonds. 

The central bank hiked its policy rate drastically Thursday, bringing it to 25% from 17.5%. It was the third and biggest hike in as many months under a new economic leadership that has pledged “a return to rational policies” after President Recep Tayyip Erdogan’s reelection in late May. Erdogan’s unorthodox view that high rates cause high inflation and his insistence on a low-rate policy in the past few years are widely blamed for Turkey’s current economic woes.

The KKM scheme helped stem a dollarization wave sparked by a series of rate cuts by the central bank at the behest of Erdogan, who sought to keep the economy warm ahead of the elections despite soaring inflation. KKM deposits have grown to about $124 billion, accounting for 26% of all deposits in Turkish banks.