For now, the lira’s selloff has calmed, with the currency regaining a chunk of the massive losses it sustained against the dollar this year. But some are skeptical about the long-term prospects. Spiraling inflation and heavy dollarization in the banking system leave this major emerging market vulnerable. 

What could trigger a worsening of the situation? A depositor run on the dollars held in Turkey’s banking system or Turkey’s banks losing access to international dollar markets would freeze the financial system. This could prompt even more drastic action from the government, including capital controls.

“In a few years, I think we’ll look back at this as when Turkey really started to turn,” said Jason Tuvey, a senior emerging markets economist at Capital Economics.

Part of the reason that Turks trust the banks is that they use them to keep not just lira savings, but their much larger store of dollars and euros. Nearly two-thirds of deposits in the banking system are held in foreign currencies.

Turks have stored their savings in dollars, gold and other hard assets for generations. But the accumulation of dollars has accelerated since the 2018 currency crisis.

Turkish President Recep Tayyip Erdogan ousted a series of central bank chiefs and has insisted on a campaign of interest rate cuts despite soaring inflation. This has undermined confidence in the lira.

“The root cause of all this is inflation. If inflation wasn’t high, the pressure to dollarize wouldn’t be an issue,” said Edward Al-Hussainy, a senior analyst at Columbia Threadneedle Investments. 

In addition to deposits, Turkish banks get dollars by borrowing them from abroad. While the amount is less than it was before 2018, it is still substantial, with around $83 billion due in the next 12 months as of September, equivalent to about 11% of the country’s gross domestic product, according to Capital Economics.

“There are still signs that banks are able to go to the market at the moment,” said Lindsey Liddell, head of Turkish bank ratings at Fitch. 

There are worrying signs, however. The rate at which banks are able to replace expiring dollar debt has fallen below 100%, meaning they are borrowing less in new loans than they owe.

Another source of risk is who Turkish banks lend their dollars to. Increasingly, they have been lending them to the government. Some go to buy Turkish government bonds issued in dollars.

The banks also lend their dollars to the central bank through its $60-plus billion in foreign-exchange swaps, a type of derivative contract. A chunk of the banks’ dollars are also held by the central bank as reserve requirements. 

The central bank has used the dollars it borrowed in these swaps to intervene in foreign exchange markets to prop up the lira. It has left the central bank with a net-negative foreign currency reserve.

A doomsday scenario, economists say, is if Turkish depositors pull their dollars out of the banks. The banks would ask the central bank for their dollar reserves back and may try to unwind the swaps. If the central bank wasn’t able to comply, the banks would be unable to pay depositors. This is similar to what happened in Lebanon’s 2020 financial crisis.

For now, there is little hint of dollar shortage in the banks. The rate Turkish banks have to pay on dollar deposits is around 0.5%, according to Goldman Sachs. That is better than savers get in the U.S. for their dollars, but not much more. That rate spiked during the 2018 crisis, but so far remains calm. 

With inflation above 20%, the lira should naturally continue depreciating against the dollar as it loses its purchasing power. The government will need to borrow, or the central bank will need to print money, to make the Turkish savers whole under the deposit plan, fueling inflationary pressures.

The plan also comes when lira loan growth is already soaring.

But there is a mystery in where those loans are going, as that money hasn’t made its way back into the banking system as deposits. This could be a sign that the money is being put into brokerage firms, which put their lira in short-term debt funds outside the banking system, or being used to purchase items or services from nonresidents. 

“Given that the inflation outlook looks pretty challenging, some of the bank clients may be taking lira loans and then they bought foreign currency or other assets like stocks or maybe even cryptocurrency,” said Ugras Ulku, head of European emerging market research at the IIF.