Central Banks

Turkey delivers massive rate hike to defend lira

What does Turkey's rate hike mean for markets?

The Turkish central bank raised its overnight lending rate to 12 percent from 7.75 percent and the overnight borrowing rate to 8 percent from 3.5 percent late Tuesday, in a surprisingly strong move to defend the country's embattled currency.

The lira immediately strengthened to 2.2 to the dollar from 2.253 after the decision. The rate hike was much sharper than expected; eight economists polled by the Wall Street Journal had expected an increase of three percentage points at the most.

Dow futures spiked 150 points on the closely watched move, while Asia equity markets opened higher as the strong action by Turkey lifted investor sentiment.

"The shock and awe of this move was important, we'll have to see now if it sticks," David McAlvany, CEO of McAlvany Financial Group, told CNBC Asia's "Squawk Box."

(Read more: Turkey: What's going on and why you should care)

Two hundred denomination Turkish lira banknotes
Kerem Uzel | Bloomberg | Getty Images

Emerging markets have come under renewed pressure in the past week, hurt by concerns about China's economy and the impact of a tapering of the U.S. Federal Reserve's monetary stimulus - especially on those countries with a high debt burden.

(Read more: Will the Fed throw emerging markets a bone?)

Local investors have been selling the lira in favor of foreign currencies, and international investors have been staying away from the Turkish currency, pushing its value down to record lows earlier this week.

The cost of Turkey's debt is also rising alarmingly quickly, with 10-year debt hitting 10.45 percent, its highest since 2010.

"The reason the lira was depreciating was because there was no confidence at all that the central bank would act appropriately," said Ed Ponsi, managing director at Barchetta Capital Management. "Tonight we have re-established trust in the central bank of Turkey."

Turkey is not the only emerging market to suffer in recent weeks, with Argentina and Ukraine both punished for political turmoil and large current account deficits.

(Read more: Emerging market currencies: A well-thought-out crisis)

Turkey rate hike signals end of EM turmoil: Pro

Yet it is a substantially bigger economy than either of these, and World Bank projections suggest it should rise from the 17th biggest economy in the world in 2012 to the 14th in 2050. Its borders with Europe, Syria and Iran are another reason it is strategically important that a stable government and economy are in place.

The activity in Turkey came as Federal Reserve officials gathered in Washington, where they are expected to cut another $10 billion from the Fed's monthly bond buying program Wednesday.

The Fed started tapering the original $85 billion program at its December meeting. The Fed's tapering program has been seen as a drag on emerging markets, following years of extra funds flowing around global markets.

(Read more: Fed taper will remain slow and steady: CNBC survey)

Analysts said the decision by Turkey's central bank was significant since it had come across as reluctant to take action.

"It's only fitting that Turkey's central bank, which has stubbornly refused to mount a proper interest rate defense of the lira, decided to hike rates in an extremely aggressive manner in the dark of night," said Nicholas Spiro, managing director at Spiro Sovereign Strategy in a note.

"The decision to raise all three main policy rates by between 425 and 550 basis points is the most significant shift in monetary policy in a vulnerable emerging market since the U.S. Federal Reserve let the "tapering" genie out of the bottle last May," he added.

Central banks in some emerging markets have started to take action to defend their markets. India, hit hard last year when Fed tapering fears first surfaced, on Tuesday delivered a surprise interest rate hike to fight inflation.

—Reporting by Catherine Boyle and Dhara Ranasinghe