By Christopher Whittall and Patricia Kowsmann 

Turkey's attempts to stabilize its embattled financial markets had borne some fruit this week, sparking a brief relief rally in the lira, but investors are still looking for ways to hedge against any new shocks.

That negative sentiment toward Turkey was on full view again on Friday, when the lira sank more around 5% against the dollar after the U.S. on Thursday threatened new penalties against the country over its detention of a U.S. pastor.

Friday's drop brought to an end three straight days of gains for the lira -- which is still up 5% this week against the dollar -- after it hit a record low on Monday. The rally came after Qatar announced a $15 billion support package and Turkey's banking regulator moved to limit the amount of the local currency banks can swap for foreign currencies with counterparts.

Investors say the intervention made it more expensive to bet on declines in the lira and helped provide some support for the currency. But analysts also warned that the measures haven't addressed concerns over the economic policies of President Recep Tayyip Erdogan, Turkey's runaway inflation, its souring relationship with the U.S. and its large foreign-currency debt that is due to mature over the next 12 months.

"I would compare it to taking painkillers when you have cancer. It will reduce the pain short term, but won't cure the underlying illness and problems of the Turkish economy," said Carsten Hesse, an economist at Berenberg.

Indeed, IMF data show that Turkey's pot of foreign-exchange reserves is ill-equipped to service its debt. Turkey's official foreign-exchange reserves stand at around $100 billion, but that figure could be inflated because of the large amounts of foreign-currency reserves and gold that Turkish banks are allowed to place at the central bank to comply with their reserve requirements.

The uncertainty over the long-term health of the Turkish economy has seen investors scramble for protection across a range of markets -- not just selling the lira.

The amount of Turkish government dollar bonds on loan -- a proxy for short demand -- has grown to $1.4 billion from $350 million at the start of the year, according to IHS Markit. In the equity market, the short position in the iShares MSCI Turkey ETF hit a year-to-date high of 4.3 million s hares this week, nearly double the short position at the start of the year.

Volumes have also been high in the credit-default swap market, according to Gavan Nolan, director at IHS Markit, where investors can buy insurance against a Turkish sovereign default.

Paul McNamara, a fund manager at GAM, said it is important to be discerning when choosing hedges. "You get what you pay for," he said. "At this point protection on most of the risks [is] expensive."

In a conference call with international investors on Thursday, Turkey's Finance Minister Berat Albayrak acknowledged the difficult conditions but vowed that his country will come out stronger, according to two participants in the call.

"With their backs against the wall, they had to do something and after this call investors might give him the benefit of the doubt," said Richard Segal, emerging-market analyst at Manulife Asset Management, who was on the call. "But there is still scope for things to go wrong."

The lira is down nearly 40% against the U.S. dollar this year. That selloff accelerated sharply last week after the U.S. imposed sanctions on Turkey over the detention of a U.S. pastor. Tensions between the two countries escalated further as Washington and Ankara levied trade tariffs on each others' goods.

Other emerging-market currencies were also under pressure Friday. The Brazilian real, Mexican peso and Russian ruble all fell 0.8% against the dollar in recent trade.

--Jon Sindreu and Georgi Kantchev contributed to this article.

Write to Christopher Whittall at christopher.whittall@wsj.com and Patricia Kowsmann at patricia.kowsmann@wsj.com

(END) Dow Jones Newswires

August 17, 2018 09:16 ET (13:16 GMT)

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