(Bloomberg) -- Turkey scrapped rules forcing banks to buy government bonds as a penalty for lending at interest rates above certain limits or falling short of targets for business loans, ending a practice widely reviled by local lenders and foreign investors.

The central bank said in a statement that it was abolishing the rules as part of its “simplification” of regulation and in order to strengthen its fight against dollarization in the economy. 

“The aim is to ease access to loans and encourage the transition to liras,” Treasury and Finance Minister Mehmet Simsek said on X, the social media platform formerly known as Twitter. Some exceptions remained, with banks still required to buy government bonds for failing to meet lending targets for certain business activities.

Lira-denominated bonds slumped after the announcement, sending the yield on the 2-year note up as much as 169 basis points to 35.2% on Friday. The yield on ten-year debt rose to nearly 30%. The banking equity index rose by as much as 2.1% before reversing to a 0.1% loss as of midday in Istanbul. 

The regulations had artificially suppressed yields on government debt for years and effectively killed the lira bond market as investors exited, refusing to buy the bonds at inflated prices. Market rates also faced distortions as banks were pushed to offer cheaper commercial loans and to deter their customers from holding foreign currencies.

The forced bond purchases were part of a patchwork of rules introduced by the central bank’s previous leadership, which complied with President Recep Tayyip Erdogan’s preferences for ultra-low interest rates and then introduced dozens of new regulations to compensate for the consequent market disruptions.   

Policy Reversal

But under Governor Hafize Gaye Erkan, appointed in June, the central bank has promised to simplify the rules. Eventually it hopes to restore the headline interest rate as its main monetary-policy tool, but officials have urged patience with a process that they say needs to be gradual and measured to avoid shocks to markets and the $900 billion economy.

“The starting point was so poor that it was never going to be easy to simplify the regulatory environment, improve the monetary transmission mechanism, and anchor inflation expectations simultaneously without creating significant headwinds for the economy,” said Emre Akcakmak, portfolio manager at Dubai-based East Capital International AB. “Are we there yet? Probably not. However, it is now a story worth following from a global investor’s point of view.”

Read more: Turkey Finally Stamps Out Credit Oddity as Hikes Lift Loan Rates

Erkan’s central bank has already raised the benchmark interest rate by a cumulative 26.5 percentage points in five meetings since June, last lifting the borrowing costs to 35% this week. It’s also signaled more tightening measures, and analysts are predicting a terminal rate of at least 40%. 

Ibrahim Turhan, a former deputy governor at the central bank, welcomed Friday’s move.

“Next up, there’s the normalization of the capital market, lira returns coming in line with market conditions and reviving the lira market abroad,” he wrote on X.

But after years of policy upheaval, many investors remain cautious and say they’ll stay on the sidelines until interest rates — which are still nearly 30 percentage points below the inflation rate — are normalized, too.

“Whilst promising, we view the current pace of monetary-policy normalization strategy as likely to fall short of reviving significant capital inflows until the central bank brings policy rates to a threshold that re-anchors price stability,” said Ehsan Khoman, head of EM research at MUFG.

--With assistance from Ugur Yilmaz.

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