Painful adjustments

This week we witnessed record hikes in the exchange rate and the US dollar going up to TL 2.07 while heavy losses continued in the İstanbul Stock Exchange. This last turmoil could be considered part of markets' struggles to adjust to new moves by the US Federal Reserve.
Indeed, since the Fed announced its intention to end its cheap money policy and laid out a road map to this end, the world economy entered a new era characterized by, let's say, normal conditions. This means relatively scarce liquidity in the international financial system, higher interest rates in US dollar-based assets and a return to moderate growth. The global macroeconomic framework of this new era requires painful adjustments for emerging economies, particularly those with high current account deficits. These economies, including Turkey's -- which has one the highest current account deficits relative to GDP in the world benefited from short-term capital inflows during the previous period, when almost $3 trillion was scattered by “helicopter Ben” (as Fed Chairman Ben Bernanke is called by his critics) over the American banking system. Some of those dollars were channeled into emerging markets. The availability of liquidity at very low interest rates fueled economic growth in these economies by boosting domestic demand and at the same time made financing the increasing current account deficit easier. Furthermore, the abundance of liquidity provoked excessive capital inflows that in turn caused excessive appreciation in local currencies. These conditions, which have prevailed since the Great Recession, are now over. Emerging countries with unbalanced external positions must adjust their basic prices, like the exchange rate and interest rates, to the new conditions. Those adjustments include a mixture of local currency depreciation and higher interest rates. Central Bank of Turkey Governor Erdem Başçı announced his own strategy on Tuesday during a dramatic interview with the Anadolu news agency, transmitted live by all Turkey's major news channels. The central bank's preferred mixture for these two basic prices consists of rather limited depreciation and moderately high interest rates. Başçı thinks that the depreciation of the Turkish lira has been excessive. The real exchange rate index dropped below 110 after the dollar-Turkish lira exchange rate exceeded TL 2. For the central bank, an exchange rate index of 120 is sufficient for external competitiveness. So Başçı has been quite confident in asserting that the exchange rate will soon get back to its “equilibrium” value. He said that an exchange rate of TL 1.92 by year's end shouldn't surprise anyone. Başçı also clarified his interest-rate policy. The policy rate, currently at 4.50, will not be touched. But central bank lending will be close to the ceiling of the daily interest rate corridor, which means an average lending rate of over 7 percent. To make this mix of exchange rate and interest rate levels effective in calming down markets and to meet inflation targets, the Central Bank of Turkey seems ready to use its hard currency reserves until the speculation against the Turkish Lira is stopped. Moreover, Başçı added that under these circumstances the inflation rate would not sink lower than the last forecast of slightly above 6 percent, while the current account deficit would shrink without a further decrease in the growth rate, which is estimated at around 3.5 percent. All these actions and forecasts from the central bank may be too good to be true. In fact, the ideal macroeconomic setup desired by the central bank, and probably the government as well, would entail adjustments that are as painless as possible for Turkey. Unfortunately, I do not believe this can happen. I agree that the Turkish lira has been excessively depreciated and think that increasing the interest rate may be useless. But I can't believe that the growth rate can be kept at its current level while the current account deficit shrinks as a result of a depreciation that could in the end hit 10 percent. It shouldn't be surprising if the unavoidable adjustments alleviate Turkey pain. Economic authorities can only mitigate the pain with the right policy mixes. Will this be the case for Turkey? Let's see.