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.

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.