In a move likely to please local markets, Turkey's banking watchdog early Friday raised the limits of currency swaps and other derivative transactions that lenders execute with nonresidents when receiving and paying with Turkish liras at the maturity date.

The move came following the Central Bank of the Republic of Turkey (CBRT) raising key policy rates earlier Thursday, which both aimed at supporting the Turkish lira and what was set to be maintaining a deflation process as the bank said that a fast recovery from the initial coronavirus pandemic shock sent inflation higher than expected.

Under the Banking Regulation and Supervision Agency (BDDK) move, when banks buy Turkish liras, the swap limit of Turkish banks has been increased from 1% to 10% of their equity.

The limit of banks for selling Turkish liras was also increased to 2% for transactions due in seven days, 5% for those due in 30 days, and 20% for those due within a year.

Commenting on the move in a client note, Enver Erkan, an economist at Istanbul-based private investment firm Tera Yatırım, said foreign investors will welcome the positive real interest rate and easing of Turkish lira transactions.

"With this normalization step, which brings relief in terms of derivative transactions made by banks with foreigners, a market-friendly move came from the BDDK after the central bank's interest rate decision," he said, referring to Thursday’s interest rate hike from 8.25% to 10.25%.

The BDDK, in its statement, emphasized that the decisions made during the period of uncertainty and risk in global markets brought on by the COVID-19 pandemic were reevaluated within the framework of normalization steps, and the decision followed this process.

Turkish lira gains strength

Following the BDDK move, the U.S. dollar-Turkish lira exchange started the last trading day of the week by continuing its decline. The exchange rate, which eased yesterday after the CBRT's interest rate hike, further, yet slightly, strengthened with the BDDK's swap step.

The Turkish lira was traded at 7.52 against the dollar, 1.3% below the previous close as of 10:20 a.m. local time. In the same minutes, it was sold at 8.80 against the euro with a decrease of 1.2% and at 9.63 against the pound sterling.

The CBRT move was a relatively unexpected step that helped boost the Turkish currency as it came as the bank’s first hike in two years and following a period of aggressive rate cuts. After hitting a series of record lows, the lira traded higher against the dollar with the decision.

Economists referred to the increase of the policy rate as a step in the right direction, interpreting it a move that would support the Turkish lira assets.

Anadolu Agency (AA) finance analyst and economist Haluk Bürümcekçi said Thursday that the central bank has expanded its room for maneuver with the increase in interest rates and that the reaction of the Turkish lira will determine whether the liquidity measures will loosen or not.

Garanti Investment chief economist Gizem Öztok Altınsaç, who referred to the decision as a positive step, said in a report published in Turkish daily Dünya on Thursday that the decision should be viewed not only as a 200-basis point increase in interest rates but also as a central bank decision that takes the inflation problem seriously.

Phoenix Kalen, the emerging markets strategy director at the Paris-based Societe Generale, told AA that the move had been unexpected by markets.

Although this is a step in the right direction, he warned that it may not be enough to sustainably steady or strengthen the Turkish lira, adding that real positive rates needed to be restored, along with the effective funding rate.

Also commenting on the decision, Piotr Matys, a strategist at Rabobank, a lender based in the Netherlands, noted that the central bank's Monetary Policy Committee (MPC) meeting was the perfect opportunity to raise the benchmark rate. "The decision is an important step in the right direction as it somewhat reduces risk to inflation and financial stability," Matys said.

With the move, the CBRT now has more room to tighten monetary conditions, according to Jason Tuvey, a senior emerging markets economist at Capital Economics in the U.K.

"We expect that the average cost of central bank liquidity provision will climb to around 12%," he said.

Meanwhile, Nigel Rendell, director for Europe, the Middle East and Africa at New York-based Medley Global Advisors, said the decision was "a big surprise for the financial markets and a welcome boost for the Turkish lira.''

Analysts also drew attention to the fact that after the decisions of both the CBRT and the BDDK, the Turkish lira was the developing currency that gained the most value against the dollar. The Turkish lira gained 1.3% against the dollar, while the South African rand gained 0.7%, the Russian ruble gained 0.4% and the Indonesian rupee gained 0.3%.