Exchange rate debate

The US dollar-Turkish lira (USD-TL) parity has become a critical issue for the fate of the Turkish economy this year since, according the headlines, Morgan Stanley predicted that the rate would continue rising up to TL 2.3 to $1 from its current level of 2.17.
This prediction fueled pessimistic forecasts in the markets. In fact, this was not the whole story told by Morgan Stanley. Indeed, one of its chief regional economists, Tevfik Aksoy, precisely said that the USD-TL exchange rate will rise up to TL 2.3 until the second quarter of the year, then it will close the year at TL 2.2 and finally it will be down to TL 2.15 by the end of 2015. Mr. Aksoy argued that the reason for upward movement of the exchange rate during the coming months is political uncertainty. Morgan Stanley also, in fact, expects a reversal in the exchange rate's movement, but within rather a longer period. The evolution of the exchange rate, specifically the duration of a depreciated Turkish lira, will be determinant of economic growth. In other words, whether Turkey will face a recession or just a year of slow growth will depend on the effects caused by the evolution of the exchange rate. I had already noted in this column the main channels through which these effects work. The first channel is the “balance sheet effect." At the aggregate level, Turkish companies are heavily indebted in US dollars and euros, but their balance sheets are in Turkish lira. When the Turkish lira experiences lasting depreciation and if the debt of a company, when denominated in hard currency, is high, the more its balance sheet will risk losses. It's needless to explain that in such circumstances a heavily indebted company may become bankrupt or may try to avoid bankruptcy by postponing investment plans and laying people off in order to use its work force more efficiently. The second channel that also adversely affects investments is the relative price of imported investment goods, which rise when the Turkish lira depreciates. Finally, the depreciation of the local currency increases import prices and then the rate of inflation is pushed up. The Turkish Central Bank cannot do without reacting to this increase, i.e, by further tightening the monetary policy since its credibility is already being questioned. The effect of a tighter monetary policy on investments and the demand for consumer durables are straightforward. Deputy Prime Minister Ali Babacan, fully aware of the matter, recently declared that the adverse effects of the exchange rate increase on inflation might only happen if this increase is long lasting. He added, "If things calm down within weeks or months, market indicators will be back to their normal levels." I have also claimed in this column that I sooner or later expect a reversal in the exchange rate and argued that the Turkish lira is actually well undervalued. In fact, the critical issue seems to be the evolution of the exchange rate in the short run, say in the coming weeks. If the Turkish lira's value continues depreciating as predicted by Morgan Stanley, or if it even remains at its current level during the coming months, we must expect a recession, at least in the first quarter. In order to understand this possibility, we need to go back once again to the fundamentals. The real effective exchange rate (REER) in December, as computed by the central bank, went down to almost 107 from about 121 in April last year. This number is considered more or less an equilibrium value, considering the catch up in productivity that occurred since 2003, the starting point of the index -- which was at about 100. One should note that in 2003, REER was quite competitive and the current account was almost balanced. It is true that we witnessed high gains in productivity from 2003 to 2008, but these gains then diminished. Nevertheless, when we consider a lower equilibrium value of the index, say for example 115, the Turkish lira would be undervalued by 5 to 8 percent. Even a reversal of 5 percent in the nominal exchange rate would scale back the exchange rate with the US dollar to around TL 2.06. This analysis is based, of course, on basic macroeconomic indicators. However, it is well known that market players do not care about the basics, particularly if the environment is fuzzy and rumors are waking up bad spirits. So, it is difficult to make a bet on the actual circumstances regarding an early reversal in the exchange rate. But on the other hand, I have to point out that, this time, investing in the US dollar also seems quite risky.