Turkey's FX Reserves Erode Amidst Iran Tensions: A Looming Gold Intervention?

Iran Crisis Casts Shadow Over Turkish Economy: Foreign Exchange Reserves Under Strain

Since the escalation of regional tensions, Turkey has witnessed a pronounced depletion of its foreign exchange reserves, sparking growing concerns among financial institutions and economic analysts. These developments have led many to question the efficacy of the Turkish Central Bank's current monetary policies and the possibility of resorting to its valuable gold reserves as a lifeline to support the national currency, the Turkish Lira.

Reserve Depletion: Desperate Attempts to Maintain Lira Stability

Over the past three weeks, the Turkish Central Bank has been compelled to expend approximately $30 billion USD from its reserves to support the Lira and attempt to stabilize its value. This figure is nearly on par with the expenditure during the financial panic triggered by the arrest of Istanbul Mayor Ekrem İmamoğlu last year. This intensive spending underscores the magnitude of the pressures confronting the Central Bank.

Kieran Curtis, Emerging Markets Fund Manager at abrdn, emphasizes the gravity of the situation, stating, "At the current rate of FX reserve depletion, the Central Bank's existing FX policy will not last long unless they sell some gold reserves."

Turkey's Strategic Position and the Vulnerability of Import Dependency

As a NATO member sharing a 550-kilometer border with Iran, Turkey is actively striving to mediate and end the ongoing conflict. However, its significant reliance on imports, particularly in the energy sector, renders it particularly vulnerable amidst these volatile circumstances.

Turkish Finance Minister Mehmet Şimşek acknowledged last week that it is "impossible" for Turkey to remain insulated from the fallout of this crisis. His primary concern lies with the current account deficit, a soft spot that could deliver a severe blow to the Lira.

Numbers Reveal: A Sharp Decline in Net Reserves

According to calculations by Bürümcekçi Research and Consultancy, based on official data, the Turkish Central Bank sold $26 billion USD in foreign exchange in the three weeks leading up to March 19th. This resulted in net foreign exchange reserves, excluding forward transactions, falling to $43.4 billion USD. Other independent economists estimate that net reserves have decreased by $34 billion USD since the conflict began.

Gold as a Safety Net: Substantial Reserves at the Central Bank's Disposal

Conversely, JPMorgan data indicates that the Turkish Central Bank holds gold reserves valued at over $100 billion USD, with approximately $30 billion USD deposited with the Bank of England. These gold reserves can be utilized "without logistical constraints" for intervention in the foreign exchange market, positioning them as a potential trump card.

Reports from Bloomberg have indicated that the Turkish Central Bank is currently exploring the use of gold swap transactions to bolster its foreign exchange reserves. Gold swaps typically involve the temporary exchange of gold for foreign currency, with an agreement to reverse the transaction at a later date to reclaim the gold.

Attempting to Rebuild Economic Credibility: Strict Policies and Mixed Results

Over the past three years, Turkey, under the stewardship of Finance Minister Şimşek (formerly Chief Economist at Merrill Lynch) and Central Bank Governor Hafize Gaye Erkan (formerly an economist at the Federal Reserve Bank of New York), has succeeded in rebuilding its economic credibility. Their policies of extremely high interest rates and a strong exchange rate regime helped reduce inflation from a peak of 85% in late 2022 to around 30% in January of this year. These measures also contributed to rebuilding previously depleted foreign exchange reserves, partly due to Turkey's current high interest rate of 37% attracting substantial foreign investor inflows.

Energy Challenges and Persistent Inflation: A Burden on Economic Stability

However, the sharp surge in energy costs has begun to permeate all facets of the Turkish economy, potentially undermining the effectiveness of its tight monetary policy. These policies, which were designed to curb inflation, stabilize the Lira, and maintain the confidence of foreign investors and domestic savers, are now facing increasing challenges.

Since the outbreak of the conflict on February 28th, the price of Brent crude oil has risen by over $30 per barrel, hovering around $102 per barrel this week. Last month, Turkey's inflation rate climbed to 31.5%, among the highest globally. Concurrently, Turkey's annualized current account deficit has widened to nearly $33 billion USD.

Looking Ahead: Prolonged Conflict and Potential Lira Capitulation

Timothy Ash, Senior Sovereign Strategist at RBC BlueBay Asset Management, notes that "Turkey has held up well and performed better than many people expected." However, he adds, "The longer the conflict continues and energy prices remain high, the more everyone can foresee what will happen: Turkey will have to let the Lira depreciate and raise rates. But if it comes to that, the whole world will suffer."

Historical Comparison: Lessons from Past Turmoil

Thus far, the Turkish Central Bank has avoided raising its key policy interest rate. This contrasts sharply with the situation in March of last year, when the Central Bank significantly hiked interest rates by 3.5 percentage points to 46% in an effort to quell the financial turbulence that followed the arrest of President Recep Tayyip Erdoğan's staunchest political opponent, İmamoğlu. At that time, the Central Bank injected up to $50 billion to support the Lira, causing net reserves to plummet to a mere $10 billion.

Multiple Pressures: Political and Economic Challenges on the Horizon

Since then, Turkey has managed to rebuild its foreign exchange reserve buffer. Nevertheless, any further economic weakening, coupled with the potential influx of Iranian refugees comparable in scale to the nearly 4 million who fled to Turkey during the Syrian Civil War, would complicate President Erdoğan's political prospects in the upcoming presidential elections, which must be held by May 2028.

Current opinion polls indicate that Erdoğan's ruling Justice and Development Party (AKP) is currently slightly trailing the main opposition party, the Republican People's Party (CHP), to which İmamoğlu belongs.