Abstract :
- Once again, a political event has triggered widespread uncertainty and financial tensions in Turkey.
- A scenario of significant capital outflows appears to be unfolding, as Turkey has attracted a considerable amount of volatile capital in recent months, particularly in connection with carry trade strategies.
- Despite a recent rebound, foreign exchange reserves are likely to be particularly affected, making the introduction of capital controls more than likely.
- Turkey has several factors working in its favor (strong bank deposits, improved corporate and banking fundamentals) that could once again help it avoid a balance of payments crisis.
- The risk of a return to dollarization of the economy cannot be ruled out in the short term, which could fuel a negative spiral of depreciation of the Turkish lira.
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Since March 19, 2025, Turkey has entered a period of financial turbulence. Once again, it is a political event[1], the arrest of Istanbul Mayor E. Imamoglu and protests across the country, that is causing macro-financial tensions. This arrest has also raised serious concerns about the potential resignation of Finance Minister M. Simsek[2], who has been a symbol of credibility in the country’s economic policy since June 2023.
The country’s stock market index fell in March, and tensions surrounding the Turkish lira have resurfaced. The Turkish lira’s loss of value in March 2025 is nothing new, as the currency had already lost nearly 92% of its value against the USD between 2015 and February 2024 due to structural weaknesses in the Turkish economy, sometimes triggered by political events (see ndbp issue 1). For some, this political crisis masks the risk of a deep financial crisis.
This note analyzes Turkey’s macro-financial situation through four telling charts in order to assess the risks of a financial crisis in concrete terms.
Capital flight seems inevitable
The political shockwave is spreading not only to the stock market but also to key financial indicators: a rise in sovereign yields, an increase in the 5-year Credit Default Swap risk premium, a widening gap between the spot price of the lira and forwards, etc. In such a context, fears of massive capital outflows are resurfacing. Such a scenario seems plausible given that Turkey is highly dependent on portfolio investment flows (but also on bank deposits), which are by nature highly volatile. This risk seems all the greater at present, given that since the return of positive real interest rates in Turkey, the country has benefited from strong interest from non-resident investors in domestic securities, such as government bonds (see chart below).
However, the enthusiasm for Turkish securities observed since March 2024 could reverse. Not only are capital inflows likely to dry up due to political and economic tensions, but the country could also see an increase in outflows. Indeed, it would appear that the sharp rise in acquisitions of Turkish securities by non-residents (totaling USD 39.2 billion in mid-March 2025[6]) was based in particular on carry trade strategies[7]. When bond yields rise, bond prices tend to fall automatically, meaning that carry trade strategies begin to lose their appeal and investors adopting this strategy should in principle unwind their positions in order to maximize their gains. This would result in the sale of securities, followed by the repatriation of profits from the transaction and, ultimately, capital outflows.
Strengthened capital controls to preserve foreign exchange reserves
To contain downward pressure on the Turkish lira (TRY), the Turkish Central Bank (CRBT) would intervene massively by selling assets to buy back its own currency. This strategy has always proved very costly for the CBRT, which has seen its foreign exchange reserves rapidly decline in such circumstances in the past. This has even led to its net reserves[8] becoming negative on several occasions (see chart below). Thanks to a change in monetary policy since 2023 and less intensive use to support the TRY, net reserves returned to positive territory at the end of 2024, but their level remains limited (estimated at nearly USD 26 billion at the beginning of 2025). Against a backdrop of capital outflows and increased support for the TRY, reserves (both gross and, even more so, net) will inevitably decline.
However, foreign exchange reserves are vital, particularly to ensure a level of foreign currency liquidity in line with the country’s external needs and commitments (mainly payment of import bills and servicing of external debt[9]). A decline in reserves would lead to a further period of foreign currency liquidity drying up in the domestic market and would weigh on financial stability. In such a scenario, the Turkish authorities would have no choice but to quickly reintroduce capital controls… Measures that they had abandoned in 2023. The authorities already banned short selling on the stock market in March 205 and are likely to strengthen their arsenal.
Resilience factors that mitigate risks
Although sometimes mentioned, a balance of payments crisis scenario does not seem to be the most likely at this stage. Turkey has weathered this type of storm several times, avoiding such a scenario even when several indicators seemed to point to an imminent crisis, as was the case in 2018 and 2020. Several factors can be identified to explain this resilience: on the one hand, continued strong growth in bank deposits and, on the other, a repeated ability to refinance external debt, albeit on less favorable terms, but nevertheless avoiding payment defaults.
Furthermore, it would appear that the country is entering this period of turbulence better equipped than in the past. This is what the chart below seems to reveal. Since mid-2023, Turkish companies and banks have managed to raise more debt than they need to repay on their external debt (rollover rate above 100, see definition in the chart), meaning that they have had some ease in finding funds on external markets to « roll over » their debt.
In addition, companies’ short-term external assets (i.e., the most liquid assets) cover nearly 110% of their short-term external liabilities[11]. This means that in the event of severely restricted access to external resources, companies would still be able to temporarily rely on their assets to meet their external commitments. In addition, regulations have been tightened in recent years to prevent Turkish companies that do not generate foreign currency revenues from taking on foreign currency debt. Companies’ ability to cover their short-term foreign currency debt with export revenues has also improved (according to the November 2024 Financial Stability Report, pages 31-32).
The looming shadow of the re-dollarization of the economy
As mentioned above, Turkey can protect itself from a balance of payments crisis thanks to the strength of bank deposits. However, there is a risk to deposits, namely the dollarization of the economy.
Between mid-2018 and the end of 2021, Turkey experienced a phase in which the share of resident deposits in TRY gradually declined, before becoming a minority, in favor of foreign currency (FX) deposits. This phenomenon occurred against a backdrop of continuous depreciation of the lira, leading to mistrust of the lira among the Turkish population and resulting in the substitution of TRY deposits with FX deposits, particularly in USD, i.e., dollarization of the economy. By getting rid of their pounds and exchanging them for foreign currencies, depositors only served to maintain, and even increase, the negative spiral on the pound.
In 2022, the authorities stepped up their measures, mainly through a mechanism known as the KKM scheme[12], which broke this spiral (see chart above, where the yellow area represents FX deposits and the green area represents TRY deposits under the KKM scheme). Since the sharp rise in key interest rates in the second half of 2023, the return on TRY deposits has proved so attractive that it has definitively reversed the trend, with deposits previously held in FX being converted into TRY. In January 2025, TRY deposits by residents accounted for 73% of total resident deposits.
However, a significant portion of these deposits are term deposits with maturities of less than six months (35% of total deposits, see red area in the chart). Once these deposits mature, there is a significant risk that, without strong new financial incentives, they will not be renewed or converted into TRY demand deposits, but rather converted into FX, as was the case in the 2018-2021 period. The longer the tensions on the lira remain high, the greater the risk of re-dollarization of the economy.
By raising interest rates, the CBRT could prevent this phenomenon from resurfacing, at least temporarily. This is probably not part of the CBRT’s initial roadmap for 2025-2026 (with inflation falling in recent months, the CBRT has been able to ease financing conditions slightly and intends to continue along this path). However, it may be forced to do so if the inflation trajectory is threatened by higher imported inflation linked to a further depreciation of the lira.
Article written on 03/25/2025
[1] Certain political events may have triggered the lira’s decline, such as the attempted coup in 2016 or, even more so, the geopolitical tensions with the United States in 2018. However, it should be noted that not all political events in Turkey over the last decade have been followed by significant movements in the exchange rate, such as: the assassination of the Russian ambassador in Istanbul in 2016, the cancellation and reorganization of elections in 2019, the arrests of opposition members (within the opposition HDP party) in early 2020, etc.
[2] Since his appointment, Turkey has entered an era of reform, ending years of « heterodox » economic policies in favor of policies aimed at reducing macroeconomic imbalances.
[3] -21% between March 18 and March 21, before the index rebounded on March 24. It should be noted that this decline in prices is still anecdotal compared to the significant increase observed after the health crisis, which was explained by Turkish companies and households seeking investments and stores of value in a context of skyrocketing inflation.
[4] Economic activity boosted by bank credit, generating high inflation and significant external vulnerabilities (high external debt, refinancing risk, insufficient foreign exchange reserves).
[5] This note does not seek to comment on or analyze the political situation in Turkey in the strict sense, but rather to use this context as a starting point for analyzing the potential economic repercussions, adopting a « ceteris paribus » approach with regard to the country’s political situation.
[6] This figure corresponds to the amounts for sovereign bonds and reaches USD 57 billion for all Turkish financial securities held by non-residents.
[7] This strategy consists of borrowing in low-interest-rate currencies in order to invest the funds raised in assets denominated in high-interest-rate currencies (see this BSI article).
[8] Net foreign exchange reserves are obtained from a calculation defined in the source of the graph, which makes it possible to assess the level of reserves that can be mobilized in the short term.
[9] Short-term external debt in foreign currencies is very significant: USD 151.7 billion, or 18.8% of GDP at the end of 2024.
[10] Probably through increased use of reserve requirement ratios in TRY and foreign currencies, and/or by requiring exporters to convert a portion of their foreign currency revenues into TRY (40% in previous measures) and/or by adjusting regulatory constraints depending on whether banks hold a significant portion of deposits in TRY or Turkish sovereign bonds, etc.
[11] While banks generally encounter fewer difficulties in refinancing their external debt, the banking sector’s coverage ratio (external assets to external liabilities) exceeded its long-term average in 2024, reaching a very comfortable level of 164%, which represents significant room for maneuver, especially compared to the 2017 level, which preceded the 2018 currency crisis, when it stood at nearly 80%.
[12] Through this scheme, the existence of a foreign exchange guarantee on FX deposits converted into TRY encouraged a rapid increase in TRY deposits . See this BSI note for more information. This extremely costly mechanism has been abandoned.
