Washington-Tokyo Alliance Falters as Japan Defends Yen via Dollar Lending

Turkey's experience serves as a cautionary tale for Washington and Tokyo, which are currently using financial engineering techniques to defend the yen without raising interest rates.

In 2021-2023, Turkey repeatedly lowered its key interest rate despite rising inflation, leading to a sharp decline in the lira and accelerating inflation to 85%.

The government then introduced the exchange-rate-protected deposit program (KKM), which allowed depositors to receive either the lira rate or the depreciation of the pound against the dollar, whichever was higher. This effectively gave depositors a free dollar call option with the strike price being the policy rate.

The KKM temporarily stabilized the exchange rate and reached an outstanding balance of about $140 billion by mid-2023, but the cost did not disappear; it was transferred to the state balance sheet and increased when the pound depreciated.