My last commentary ended with the following sentence: What is behind this 'terrifying' purchase-sale traffic in the exchange rate market if it is not the need of foreign exchange purchase and sales required for exports and imports? Since international capital movements are at significant amounts, the primary candidate for the answer goes like this: the difference between the expected returns on domestic bonds (of the country to which capital flows) and the expected returns on the bonds of country where capital flows out of. Largest the difference, expected FX inflow to the country (domestic) increases.

This is the main reason for the accusations to the CBRT (Central Bank of the Republic of Turkey) for implementing high interest rate policy. In order to calculate the difference of returns I mentioned above, you have to subtract the sum of foreign interest rate and expected increase in exchange rate from domestic interest rate. Expected increase in the exchange rate is considered since the foreign investors purchasing domestic bonds will soon sell it and convert into FX. So higher the exchange rate then, lower amount of FX will he receive. But he does not now the value exchange rate will take then when he decides to enter the domestic market. So, he has to set an expectation.

Since higher this difference is, higher the amount of FX attracted will be, FX surplus will be faced lowering the value of FX. So, as domestic interest rate increases, exchange rate will decrease. Exchange rate is a significant determinant for inflation rate. So, the CBRT is criticized for pushing up interest rates and thus lowering exchange rates in order to reduce inflation. This is also why the President of Turkish Exporters' Assembly congratulated the CBRT for lowering the short term interest rate in its last meeting (though the CBRT did not cut the interest rate as I also told on Sunday).

However the issue is not that simple: It is not the CBRT interest rate that is important for the difference between returns that foreign investors calculate. It is the interest on the bonds they are to purchase. If domestic interest rates rise as a result of increasing domestic risks, the appetite of foreign investors to purchase domestic bonds can decrease despite high interest rates. So, FX inflow decreases and even FX outflow might be witnessed. As FX supply tightens, FX appreciates. That is we can witness high interest rates together with high exchange rates. Of course this is not necessarily the case. If interest rates increase without risks rising, difference between returns would certainly be attractive; FX inflows increase and 'high interest rate low exchange rate' phenomena occurs.

The moral of the story goes like this: It is awkward to expect that every time interest rates increase, foreign investors will go crazy running "Oh God! Interest rate in Turkey is so high, we cannot miss this opportunity." It is also important why interest rates increased.

This fact I mentioned should always be kept in mind before asking the CBRT to cut interest rates. If we have a policy that will increase the exchange rate, it should be used without pushing up the economic risks. It is evident that in an environment where risks climb and thus domestic demand falls and unemployment rate increases, a hike in exchange rate will be of no use for anyone.

Therefore, for those who wants a reduction in interest rate to some level or another, the following question proves of importance: which level of interest rate can increase the exchange rate without creating the impression that monetary policy has 'cut loose' and thus pushing up the risk perception?

This commentary was published in Radikal daily on 23.09.2010