The exchange rate debate

Economy Minister Zafer Çağlayan on Thursday, answering a question from a journalist about the actual level of the exchange rate, criticized Turkish Central Bank Governor Erdem Başçı for his announcement of the real exchange rate level.
Minister Çağlayan & Governor Başçı Indeed, Governor Başçı had said in August that it would not be a surprise if the US dollar-Turkish lira exchange rate drops to TL 1.92. Mr. Çağlayan said he thinks the governor should not have announced a figure for the exchange rate and that this was an error because it is not realistic. Mr. Çağlayan added that economic managers must not set such targets in a floating exchange rate regime. This intervention by Mr. Başçı is considered by economic actors as setting an implicit target for the exchange rate. According to standard macroeconomic theory, in a floating exchange regime, central banks cannot target both an inflation rate and an exchange rate since capital can freely move in and out. I also have some doubts about implicit exchange rate targeting from a theoretical point of view but I know that at the same time, the standard macroeconomic theory is evolving under the pressure of events but nevertheless still lags far behind them. Governor Başçı had made this announcement when the lira was under speculative attack because of increasing US Treasury bonds interest rates caused by the Fed's intention to gradually end its asset purchase program. The depreciation of the lira seemed uncontrollable at the time. I believe that Başçı's announcement contributed to stopping speculation against the lira. Indeed, the dollar exchange rate has since been rather stable. Considering the exchange rate volatility in emerging economies, Turkey was the best performer. In other words, it is the country with the least exchange rate volatility in recent times. Mr. Çağlayan's criticism of the Central Bank of Turkey is not new. The economy minister is more focused on foreign trade as well as on current account performances. The central bank governor is responsible for inflation performance. Mr. Çağlayan prefers an undervalued lira in real terms while Mr. Başçı prefers the value of the lira to be as stable as possible in real terms around the equilibrium real exchange rate level. The usual problem is, quite naturally, how to determine this equilibrium level. Macroeconomic theory does not have a magic formula in this respect. In practice, it is admitted that the real exchange rate level which produces a balanced or sustainable current account balance -- with sustainability defined specifically for each country -- might be accepted as the equilibrium real exchange rate. Thus, considering the Turkish case, the graph below can help us predict an equilibrium real exchange rate and, at the same time, better understand the arguments of Mr. Başçı. The real exchange rate graph starts in 2003, the year where the current account deficit (CAD) was quite low. Let me point out that at the end of 2001, the lira had lost almost 30 percent of its real value in real terms compared to its real value just before the infamous crisis of February 2001, causing a terrible exchange rate shock. Taking the 2003 mid-year real exchange rate level as the basis point (=100) and increasing it by 2 percent each year for productivity catch-up (the famous Balassa-Samuelson effect) -- i.e., for higher productivity gains compared to our trading partners -- the index indicates that 120 can be accepted as the equilibrium level for 2013. As can be observed in the graph, the real exchange rate evolved often over the path of the equilibrium rate (the first line in the graph) except in the last two years. According to figures published a few days ago, the index, standing at 110 in September, maintained this level in November, 10 points below the so-called equilibrium level. So, the bottom line of the debate is this: According to Mr. Başçı, the lira is slightly undervalued and there is thus room for appreciation without jeopardizing the external balance. A 5 percent appreciation, for example -- bringing down the nominal exchange rate to TL 1.90 -- would not be a surprise. However, according to Mr. Çağlayan, the actual level of the real exchange rate or, in other terms a dollar rate of over TL 2, is good for exporters and thus for the economy.