Stabilizing the Lira: Turkey's Central Bank Battles FX Volatility in 2025

The Turkish Central Bank (TCB) has embarked on an aggressive policy campaign to curb foreign exchange (FX) volatility, with Governor Fatih Karahan emphasizing the institution’s commitment to preventing excessive fluctuations in the Turkish lira (TRY). Amid geopolitical tensions, capital outflows, and inflationary pressures, the bank’s measures—ranging from interest rate hikes to macroprudential tweaks—aim to fortify the lira’s stability. However, the path to sustained resilience remains fraught with challenges.

Key Policy Measures and Their Impact

1. Interest Rate Adjustments:
   The TCB’s most potent tool has been its monetary policy rate hikes, which surged to 46% in April 2025 from 42.5% in March. By further raising the overnight lending rate to 49% in May, the bank aimed to tighten liquidity and deter speculative attacks on the lira. These moves, while inflationary in the short term, have temporarily stabilized the TRY/USD exchange rate, which had plummeted to a record low of 42 per dollar earlier this year.

2. Macroprudential Reforms:
   The May 3, 2025, announcement of a 200-basis-point increase in reserve requirement ratios (RRRs) for foreign currency deposits marked a strategic shift toward reducing reliance on external funding. Coupled with a 400-bps hike for FX repo transactions, these measures withdrew $4.2 billion in liquidity, curbing banks’ ability to speculate on currency swings.

3. FX Market Interventions:
   The TCB’s introduction of lira-settled forward transactions and its commitment to spending $25 billion in reserves to support the lira have bolstered market confidence. These steps, alongside a 35% minimum FX conversion requirement for exporters, have helped stabilize foreign exchange reserves, which began rising by March after a prior decline.

Context: Why FX Volatility Matters for Investors

Turkey’s economy remains highly vulnerable to external shocks. A widening current account deficit (projected at $7.75 billion in May) and elevated political risks—such as the detention of Istanbul Mayor Ekrem İmamoğlu—have fueled capital outflows. The lira’s volatility impacts not only import costs but also inflation expectations: year-end inflation expectations rose to 30% in April, up from 18% in late 2024.

Challenges and Risks

1. Structural Deficits:
   Despite policy success in halting the lira’s freefall, Turkey’s reliance on short-term capital inflows and persistent trade imbalances pose long-term risks. A $25 billion trade deficit in Q1 2025 highlights the economy’s vulnerability to global commodity price fluctuations.

2. Geopolitical Uncertainty:
   Tensions with the EU over visa policies and ongoing legal battles involving opposition figures threaten investor sentiment. A spike in Turkey’s five-year CDS premiums to 296 basis points in March underscores heightened credit risks.

3. Inflation Persistence:
   While annual inflation fell to 38.1% in April, core inflation (excluding volatile food and energy prices) remains sticky. Services inflation—driven by housing costs—remains a wildcard, complicating the TCB’s exit strategy from ultra-tight policy.

Conclusion: A Fragile Equilibrium

The TCB’s policies have achieved measurable short-term gains: FX reserves stabilized by March, TRY depreciation slowed, and inflation expectations were partially anchored. However, the central bank’s success hinges on addressing deeper vulnerabilities. Key data points underscore the fragility of progress:

• The TRY/USD rate has fluctuated between 37 and 42 since January, reflecting persistent uncertainty.
• The BIST 100 index dropped 7% in April as geopolitical risks mounted, signaling investor caution.
• The TCB’s 5% inflation target remains distant, with current projections pointing to a year-end rate of 24%, per its May 2025 estimate.

Investors should weigh the TCB’s technical prowess against systemic risks. While the lira’s stabilization is a tactical win, sustainable stability will require fiscal discipline, trade rebalancing, and political calm. Until then, Turkey’s FX market remains a high-reward, high-risk frontier.