Capital movements are free in many countries for long. Substantial FX trade is carried out every day. Purchase and sale of different currencies depends on the expected return on the financial assets denominated in the relevant currencies, which are planned to be held.

Expected returns are determined by a number of factors the majority of which are related with the future. For instance, following factors have great importance:  When the FED will start increasing interests? Will the loosening of the fiscal policy continue? Will the rest of the world follow Germany? Will an intervention be made to Iran? Will the ruling party change after the 2011 elections? What will be the economic policy of the new ruling?  You can write a number of commentaries on the basis of these questions, but let me stop here.

In brief, it is almost impossible to estimate the future value of exchange rate. You can demand a certain level for the profitability of exports. However how can you drag the rate to the desired level given that it is affected by a number of factors? What if those factors move the rate to the opposite direction?

After stating this, we have to note one other point: it is easier to increase the exchange rate than decrease it. But in which economic environment the exchange rate changes is also of importance. You can easily enable the depreciation of the domestic currency by 'messing' the economic policy. However this obviously is not desirable as risks would rise and growth rate would fall in such an environment. On the other hand, it is not easy to lower the exchange rate to a more competitive level without 'messing' the economic policy. And in a state where capital movements are freed, there are limited steps the Central Bank can take to achieve a competitive exchange rate. I have written on these several times before. But let me summarize it.

First, volume of daily FX purchase can be pushed up; but there is an upper limit. Second, if inflation rate could permanently be limited at the 5-6% margin, the method of implementation of the inflation targeting regime can be changed. With this, the weight of the real value of exchange rate on interest rate decisions could be solidified.

Nonetheless, none of these policy changes would have a considerable impact on the exchange rate. The most effective measure the Central Bank could take is cutting the policy rate. However, as I also mentioned before, this reduction of the rate should not be considered as a 'massing' of the economic policy.

In this perspective, the responsibility should be assumed by the political power in terms of both fiscal policy and structural reforms. To put it differently, an inflation rate permanently limited at 5% level would imply a milieu where low interest rates would appear.

How can we enable such milieu? To begin with, fiscal rule should be strengthened in terms of supervision and transparency and then become a law. Second, practices pushing up the public sector goods and services that are used every time public discipline is lost must be ceased. Third, low savings rate of Turkey should be increased to lower the dependency on foreign exchange. In this context, for instance the first step to take can be examining how informality would be tackled and thus the tax revenues of the public sector can be improved.

In the meanwhile, the feasibility of the measures to limit short term capital movements must be analyzed. As nowadays international institutions including the IMF and the World Bank search for the answer to this question; Turkey should also be involved in the discussion platform.

This commentary was published in Radikal daily on 30.09.2010