Turkey's Tax Overhaul: Navigating Lira Deposits and Currency Substitution Risks

The Turkish government's recent tax reforms on lira deposits aim to stabilize the currency and curb capital flight, but investors remain wary. With inflation still elevated and geopolitical tensions simmering, the lira's attractiveness as a store of value is fading. This article examines how tax policy changes are shaping currency substitution risks and offers strategies to navigate these dynamics through asset allocation.

Tax Policy Tweaks: A Band-Aid on a Bullet Wound?

Turkey's 2025 tax reforms introduced tiered withholding rates to incentivize long-term lira deposits. For instance, interest on lira deposits over one year faces 0% tax if tied to inflation, while shorter-term deposits face up to 10% withholding. The goal: reduce currency substitution by making lira assets more competitive.

However, the lira's chronic weakness persists. Inflation, though down to 37.9% in April 2025 from a peak of 75.5% in 2024, remains elevated. Meanwhile, short-term lira deposit yields—already hit by the central bank's gradual rate cuts—now face higher taxes. This creates a yield trap: even “safe” lira deposits offer low real returns, pushing capital toward dollars or inflation-hedged assets.

Currency Substitution: A Self-Fulfilling Crisis

The reforms have not halted the flight to dollars. Foreign currency deposits (KKM accounts) still hold $17 billion as of mid-2025, down from $140 billion in 2023 but still a risk. Why?
1. Real Yield Collapse: Even with 42.5% policy rates, inflation erodes lira returns. A one-year lira deposit yielding 28% (after tax) lags behind inflation.
2. Geopolitical Uncertainty: Tariffs on Turkish exports and regional instability fuel dollar demand as a safe haven.
3. Equity Outperformance: The BIST 100 index has gained 15% in USD terms since late 2024, while lira deposits lost value.

Asset Allocation Strategies: Hedging Against TRY Depreciation

Investors must prioritize capital preservation while capitalizing on structural opportunities. Here's how:

1. Overweight USD-Denominated Debt

Turkish corporate bonds in USD often yield 8-10%, far above Treasury notes. For example, Turkish Airlines' USD-denominated notes (due 2030) offer 9.5% yield—a 500 bps premium over lira bonds. Pair this with USDTRY forwards to lock in exchange rates, shielding against further lira slippage.

2. Equity Exposure with FX Hedging

Turkish equities with dollar revenue streams or hedging tools are resilient. Tüprag (TPRG), a steel producer, benefits from global commodity pricing and has a 4.2% dividend yield. Use inverse ETFs (e.g., TURX) or currency swaps to hedge equity gains against TRY depreciation.

3. Short-Term Lira Instruments with Inflation Ties

Opt for CPI-linked deposits or bonds (e.g., CPI-indexed 10-year TRY bonds) offering 28% yields, which match current inflation. Their 10% reserve requirements make them scarce, but they're critical for investors needing lira exposure.

Avoid: Short-term lira deposits (<6 months). Their 10% tax and 20% pre-tax yield lag behind inflation and USD assets.

Conclusion: Pragmatic Hedging in a Volatile Landscape

Turkey's tax reforms are a step toward stabilizing capital flows, but structural risks remain. Investors should prioritize diversification into USD assets and hedged equities, while using inflation-linked lira instruments for tactical exposure. Monitor central bank policies closely—sudden rate cuts or geopolitical shocks could trigger renewed lira sell-offs. In this environment, hedged strategies are not optional; they're essential.

Stay vigilant, but stay invested—Turkey's recovery hinges on investors who balance risk with discipline.