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The Turkish lira was under severe pressure on Monday as an intervention by the country’s central bank, and defiant words from president Recep Tayyip Erdoğan, failed to to quell investors’ fears that the country’s financial crisis could spread to European markets

The lira pulled back from a fresh record low overnight, when it fell around 9% to 7.2 lira against the dollar, after the central bank pledged to provide liquidity for Turkish banks and gave them more breathing space by cutting their lira and foreign currency reserve requirements.The euro was also hit a one-year low against the dollar, reflecting fears of contagion for the European banking sector.

However, the lira’s recovery in afternoon trading remained weak – at 6.9 to the dollar – as president, Erdoğan followed the central bank’s comments with a claim the US was trying to stab Turkey in the back.

Q&A

Why is the lira falling so fast?

Addressing Turkish ambassadors in Ankara, Erdoğan said his country was under an economic “siege” but would overcome the “attack” on its economy. He insisted that Turkey’s economy remained strong and said the lira would soon settle “at the most reasonable level”.

The Turkish authorities also launched investigations into hundreds of social media accounts for alleged reports they claimed were aiding the currency’s plunge.

Turkey’s central bank pledged to provide “all the liquidity the banks need”. It added: “[We] will closely monitor the market depth and price formations, and take all necessary measures to maintain financial stability, if deemed necessary.”

Lira v US$

However, the Ankara-based bank has not raised interest rates, which some economists argue is necessary to alleviate the crisis because it will curb inflation and deter investors from selling the lira. Erdoğan has warned against raising borrowing costs.

The Turkish finance minister, Berat Albayrak, who is Erdoğan’s son-in-law, said at the weekend that authorities would start implementing an economic action plan on Monday morning. He rejected capital controls as an option to stem outflows of hard currency.

Following his comments, Turkey’s banking regulator announced late on Sunday that it would limit the ability of the country’s banks to swap the lira for foreign currency.

Investors are concerned about the exposure of European banks, including Spain’s BBVA, Italy’s UniCredit and France’s BNP Paribas, which have big operations in Turkey. European bank shares had dropped 1% by Monday afternoon.

The FTSE 100 was down 0.4% on Monday afternoon, with Germany’s Dax down 0.4% and the CAC in Paris trading flat in the wake of heavy losses in Asia overnight.

Turkish inflation chart

The Turkish stock market lost 3.5%, with some bank stocks suffering double-digit losses. The Russian rouble, South African rand and the Mexican and Argentine pesos – other emerging currencies that could be at risk – also fell.

Fiona Cincotta, a senior market analyst at City Index, warned that the slump in the lira could prompt some companies to default on their US dollar loans, triggering a domino effect.

“For the time being Turkey’s financial crisis looks localised but the country’s central bank has perhaps only days to stop the decline of the currency before the lira’s freefall results in loan defaults, starts seriously affecting the country’s financial system and potentially starts spilling over on to European banks.”

The falling lira fuelled demand for safe havens, including the greenback, Swiss franc and yen. The Vix volatility index measuring turbulence in financial markets – also known as the fear index – jumped 16%.

The lira has tumbled more than 40% this year on worries about Erdoğan’s increasing control over the economy and worsening relations with the US, chiefly over the war in Syria.

The US sanctioned two ministers in Erdoğan’s government in a spat over the continued detention of an American pastor in Turkey, and doubled tariffs on Turkish steel last week.

While the Trump row helped trigger a run on the lira last week that continued on Monday, the market moves against the Turkish currency reflect deeper problems for one of the world’s largest emerging economies. Turkish companies have made significant borrowings, including large amounts in dollars, and have raised $220bn (£172bn) in debt – which has become more expensive to repay as the lira has fallen.

The central bank is under pressure to increase borrowing costs – despite Erdoğan’s misgivings – as a countermeasure against rising inflation and capital flight. However, some economists warn this could also push Turkey into a recession.

European banks’ exposure to foreign debt

Andrew Kenningham, the chief global economist at Capital Economics, said: “The plunge in the lira, which began in May, now looks certain to push the Turkish economy into recession and it may well trigger a banking crisis.

“This would be another blow for emerging markets as an asset class but the wider economic spillovers should be fairly modest, even for the eurozone.”

On Sunday Erdoğan accused foreign countries of waging war on Turkey and said his government would respond with trade measures to reduce reliance on the dollar and US markets.

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