Assessing the Turkish Lira's Real Effective Exchange Rate and Its Implications for Foreign Investors

The Turkish lira's real effective exchange rate (REER) has long been a barometer of the country's economic vulnerabilities and political turbulence. By May 2025, the lira's REER had fallen to 71.11 (CPI-based) and 93.09 (PPI-based), marking a consistent weakening against major trading partners. This decline, driven by the faster appreciation of foreign currencies like the U.S. dollar and euro—up 1.75% and 2.37% respectively—has outpaced domestic inflation (1.53% for CPI, 2.48% for PPI), eroding Turkey's export competitiveness. For foreign investors, this dynamic raises critical questions about the sustainability of capital flows and the risks embedded in Turkey's emerging market.

The Mechanics of Devaluation and Investor Behavior

Currency devaluation often acts as a double-edged sword. On one hand, a weaker lira could, in theory, boost exports by making Turkish goods cheaper. Yet, in practice, the benefits are muted by Turkey's import-dependent energy and manufacturing sectors. The lira's sharp depreciation in March 2025—spiking to 42 per dollar after the politically charged arrest of Istanbul Mayor Ekrem İmamoğlu—exacerbated these challenges. Foreign equity inflows, which had briefly rebounded in 2024, reversed course. The BIST 100 index, a proxy for Turkish equities, fell 1.25% within hours of the political shock, while the banking sector index dropped 0.58%.

For equity investors, the lira's instability compounds risks. A weaker currency increases the cost of servicing foreign debt for local firms, many of which have large dollar liabilities. This was evident in the 2045-due dollar bond, which fell to 85 cents on the dollar, and the 5-year CDS widening to 292 basis points. The Central Bank of the Republic of Turkey (CBRT) responded with a surprise interest rate hike to 46%, draining $40 billion in foreign exchange reserves—a costly but necessary measure to curb panic. Yet, higher rates risk stifling growth in a labor market where unemployment remains stubbornly high at 8.6%.

Historical Context: A Trend, Not an Anomaly

The lira's REER has depreciated steadily since 2020, with the USD/TRY rate alone dropping 20.46% over 12 months as of June 2025. This trend reflects structural issues: high inflation (averaging 24% in 2025), political polarization, and a central bank that has cycled through aggressive rate cuts and hikes. The Bank for International Settlements' Real Broad Effective Exchange Rate (RBTRBIS) index, normalized to 2020=100, shows the lira losing over 30% of its real value against a trade-weighted basket.

Historically, Turkey's currency crises have been closely tied to political events. The 2025 devaluation, like those in 2018 and 2021, was triggered by domestic instability. For foreign investors, this pattern underscores the lira's sensitivity to political risk—a factor that remains unresolved despite recent credit rating upgrades from Fitch. The CBRT's projections of inflation falling to 8% by 2027 hinge on a fragile assumption: that political tensions will not escalate further.

Strategic Considerations for Foreign Investors

For equity investors, hedging against currency risk is paramount. The lira's volatility makes unhedged exposure perilous, particularly for those with short-term horizons. However, long-term investors might find value in Turkey's undervalued equities, provided they can tolerate political and macroeconomic shocks. The banking sector, for instance, offers high yields but carries elevated credit risk due to its foreign-currency debt exposure.

Debt investors face a starker trade-off. While Turkish sovereign bonds yield 15–26%, these returns must be weighed against the likelihood of further devaluation. The 5-year CDS at 292 basis points reflects this risk, but it also suggests that the market is not yet pricing in a full-blown crisis. A diversified approach—limiting exposure to dollar-denominated Turkish debt and offsetting it with short positions in the lira—could mitigate losses.

The Path Forward

The CBRT's aggressive rate hikes and foreign exchange interventions have bought time, but they are not a solution. Turkey's economic recovery depends on two factors: sustained orthodox monetary policy and political stability. The latter is the bigger unknown. With the 2028 elections looming, the risk of renewed political crises remains high.

For foreign investors, the key takeaway is clear: the Turkish lira's devaluation is not an isolated event but a symptom of deeper structural and political fragility. While Turkey's emerging market offers growth potential, it demands a cautious, hedged approach. Those who enter the market must do so with a clear-eyed understanding of the risks—and the flexibility to adjust as circumstances evolve.