Turkish lira banknotes are seen in this illustration taken in Istanbul, Turkey November 23, 2021.
Turkish lira banknotes are seen in this illustration taken in Istanbul, Turkey November 23, 2021. Reuters / MURAD SEZER

Turkey's lira tumbled more than 2% against the U.S. dollar on Wednesday and its bonds dropped sharply as worries grew over a surge in inflation and depleted official reserves, fuelled by President Tayyip Erdogan's pledge this week to continue cutting interest rates.

The lira weakened as far as 17.196 to the dollar, heading toward the record low of 18.4 it hit on Dec. 20 during a currency crisis triggered by a series of unorthodox interest rates cuts.

The currency has weakened in 12 of the last 14 sessions and shed 22% this year, after a 44% loss last year. The depreciation, combined with annual inflation of 73%, has left households badly strained ahead of elections set for mid-2023.

Erdogan set off the latest bout of weakness after a cabinet meeting on Monday when he said Turkey will not raise rates but rather continue cutting them in the face of high living costs.

"Given the imbalances, an economic soft-landing seems to be the best-case scenario but achieving that is not going to be easy or desirable ahead of the elections," said Emre Akcakmak, Dubai-based senior consultant to East Capital.

The central bank has used its foreign reserves to support the lira since the December crisis, prompting traders to call it a managed market or a "dirty float".

Government officials are looking for exchange-rate sustainability, a senior banker told Reuters, adding that corporate foreign currency demand due to import payments was observed in the market.

"The policies emphasise sustainability in the exchange rate. I see the latest weakening as a healthy move in FX policy because a heavier price will be paid if this is not done," said the banker, requesting anonymity.

The central bank's net foreign reserves were $12.2 billion at the end of May but they are deeply negative once swaps are deducted. With limited success, Turkey has sought foreign currency swap lines to help restore its buffer.

The lira has been the worst performer in emerging markets for several years due largely to economic and monetary policy concerns under Erdogan's government.

Sovereign dollar bonds also felt the pain with yields pushing into the double digits, Refinitiv data showed.

Turkey five-year credit default swaps soared 32 basis points (bps) from Tuesday's close to 769 bps, levels last seen during the global financial crisis in 2008, data from S&P Global showed.

Yields on the local 10-year government bond added more than 200 basis points on the day to 24.78%.

"Recent comments on lowering interest rates may have accelerated the lira weakness, but there are many more fundamental reasons behind it," Akcakmak said.

A soaring trade deficit, an accelerated drop in the central bank's foreign reserves, rising external financing costs and "unstoppable inflation" are all pressuring the lira, he added.