* Overnight swap rate surges to 1,200 percent in London
* Lira weakens 2 percent after selloff, rebound
* Analysts call for more long-lasting action beyond election (Adds banking assoc chairman denial of banks squeezing liquidity)
By Orhan Coskun, Nevzat Devranoglu and Ebru Tuncay
ANKARA/ISTANBUL, March 27 (Reuters) - Turkey will keep directing its banks to withhold lira liquidity from a key foreign market at least until after local elections on Sunday, sources said, as the government intensifies efforts to defend the currency, which plunged last week.
The government’s stop-gap measure to restore confidence in the lira, which remains unsteady after a crisis last year, helped send the London overnight swap rate rocketing to 1,200 percent on Wednesday. That was by far its highest on record and so high that economists said it was no longer based on actual trading.
That presented a massive hurdle to foreign investors looking to bet against the Turkish currency or to hedge or close out positions, so they sold off holdings in Turkish stocks and bonds which came under heavy pressure for a fourth straight day.
The government’s move is temporary and aimed at heading off “speculative attacks,” one of the three sources familiar with the matter told Reuters.
Investors and economists, however, responded with another round of calls for longer-lasting reforms to the economy to dissuade a growing number of Turks from losing confidence in their currency and turning to foreign cash.
However, the Turkish banking association head denied the reports in a statement to Reuters, saying lira swap rates were not surging due to banks withholding liquidity from foreign banks.
Huseyin Aydin said the reason behind the rise in lira swap rates was that there was not enough lira for foreign banks to buy dollars, and added that Turkey had shown the necessary stance against a speculative attack on the lira.
“Investors who try to buy large amounts of foreign currency quickly with the thought that the lira is cheap and will remain that way were not able to find lira for the foreign currency that they acquired,” Aydin said.
While the lira came under fresh pressure on Wednesday, weakening more than 2 percent to 5.4440 against the dollar in volatile trading, steps taken by the central bank in recent days have succeeded in erasing its steep losses on Friday. Last year the lira lost nearly 30 percent of its value.
“When liquidity returns to the market, participants will be able to express their sentiment towards the lira in an unconstrained way,” said Piotr Matys, emerging market forex strategist at Rabobank.
“It is crucial that (Turkey) starts implementing reforms as soon as possible after the local elections to restore confidence in the lira.”
Others in the market said foreign investors, squeezed out of the FX swap market, sold stocks and bonds to get hold of lira and close out positions.
Turkey’s main BIST 100 index tumbled 7 percent, with the banking index down 8 percent, in its fourth straight day of losses. In another reflection of growing investment risks, the benchmark 10-year bond yield rose to 18.72 percent, its highest since October.
The London overnight swap rate spiked to 1,200 percent from 330 percent on Tuesday and 24 percent just last week. The weekly rate jumped to 200 percent from last week’s 22 percent, Refinitiv Eikon data showed.
Turkish President Tayyip Erdogan is campaigning hard ahead of nationwide municipal elections set for Sunday in which his AK Party could lose control of Ankara and other big cities.
The source told Reuters the move to direct Turkish banks to withhold lira liquidity in London “will continue until after the elections.”
“The lira is very tight abroad,” the source added. “These sort of steps aren’t policies that can be implemented in the long term. They are done for 10-15 days and during speculative attacks.”
The jump in swap rates was so extreme that it echoed in the normally very efficient lira-dollar spot market, where an unprecedented gap of nearly 2 percent emerged between on- and off-shore rates, said Istanbul-based strategist Murat Gulkan.
A London-based FX trader said that while some speculative traders surely lost money in the borrowing squeeze, “the currency is still weakening and long-term the capital flight will continue and the currency will continue to devalue.”
The lira had weakened to 5.8490 on Friday before settling at 5.7625, its lowest closing value since October.
The currency’s meltdown on Friday marked its worst performance since August when a full-blown crisis took hold and tipped Turkey’s economy into a recession that could last deep into this year.
The government has launched investigations into bankers, alarming foreign investors, alongside the central bank’s “back door” measures to control liquidity.
Nikolay Markov, a senior economist at Pictet Asset Management, said the overnight swap rate was not an effective interest rate rise but an implied one.
“It reflects the fact the policy the central bank is following is not the right one. The right tool would be to hike rates,” he said. “That would be the most urgent action to stop the dollarisation of the economy.”
Late on Monday, Turkish banks started to keep lira swap market transactions in London well below a 25-percent limit set by the banking watchdog, four sources told Reuters on Tuesday, causing overnight and weekly swap rates to soar.
Additional reporting by Can Sezer in Istanbul and Tom Arnold and Sujata Rao in London; Writing by Daren Butler and Ezgi Erkoyun; Editing by Jonathan Spicer and Hugh Lawson