The Turkish lira recovered from its record low in Tuesday morning trading, strengthening around 6 percent against the dollar after Turkey's central bank pledged to provide liquidity.
The beleaguered currency has lost 28 percent of its value against the greenback since August and more than 40 percent this year amid investor fears over central bank policy and escalating disputes with the United States.
Monday saw the lira hit a record low of 7.2362 to the dollar, down nearly 10 percent in one day. It was trading at around 6.5300 on Tuesday 11:50 a.m. Istanbul time (4:50 a.m. ET). Turkey's BIST 100 Index was up 1.4 percent.
The central bank of Turkey has suggested a first step toward tightening monetary policy via an interest rate corridor, rather than the benchmark rate, and its reserve requirement moves will free up 10 billion lira ($6 billion) and $3 billion of gold liquidity in the financial system, the bank said.
The bounce back may stem from "relief that the [bank] got through yesterday without resort to capital controls, or some more extreme scenario," said Timothy Ash, senior emerging markets strategist at Bluebay Asset Management, who added that there was so far no run on Turkey's banks. "And the central bank finally came to the table with some behind the scenes tightening."
Turkey's markets were rocked the previous week as President Donald Trump announced sanctions on Ankara over its continued detention of American pastor Andrew Brunson, who is held on charges of espionage and involvement in Turkey's failed 2016 coup. Brunson and the U.S. government deny the charges.
As the lira fell on the sanctions news, Turkish President Recep Erdogan urged his countrymen to buy lira as part of a "national struggle" and claimed the U.S. was waging "economic warfare" on its NATO ally.
But Turkey's problems were a long time in the making, with the lira severely weakened long before Washington ever issued sanctions warnings. Erdogan has openly advocated against his central bank raising interest rates despite an overheating economy with more than 15 percent inflation and a widening current account deficit.
Investors have not been reassured over the central bank's independence as it continues to avoid hiking rates, particularly on the back of Erdogan's new and more powerful executive presidency, won in a snap election last June.
"As quickly as the issues escalated in the last four to five weeks, a solution could be found, (through) assurances from the central bank on what they're doing," said Tomas Kinmoth, fixed income strategist at ABN Amro, speaking on CNBC's "Squawk Box Europe" on Tuesday. "It's in the Turkish government's hands to show how the central bank can be independent."
The lira's drop has hit several European banks with high exposure to Turkey, as the weakening lira makes it significantly harder for Turkish corporates to repay their foreign currency-denominated debt. Turkish corporate debt to gross domestic product (GDP) is 70 percent, with foreign currency debt at 35 percent.
The selloff also hit emerging markets more broadly, sparking fears of contagion, as the South African rand and Indian rupee saw sharp drops along with all of their emerging counterparts. The MSCI Emerging Markets Index on Monday hit its lowest point since early 2016, erasing a July rebound in stocks. Turkey has the highest current account deficit among emerging markets.
A vicious spiral
Despite Tuesday's sharp recovery, Turkey's current problems are too deeply-rooted to allow for a more sustained recovery, according to Nick Brooks, head of economic and investment research at Intermediate Capital Group.
"It's likely to get worse before it gets better," Brooks told CNBC. "Erdogan does not want to raise interest rates… We're now in that awful vicious spiral environment where until rates are increased, the lira will remain under pressure, and if the lira remains under pressure there are valid concerns over corporate solvency and banking crisis."
It may seem contrary to call for raising interest rates to save the corporates. But raising them substantially in the short term and stabilizing the lira would save many corporates that have substantial foreign debt, Brooks said.
"If the lira continues to fall, a lot of that debt is not going to be repaid, and that will feed through the banking system, and we continue with that vicious spiral."