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    When is it wrong to comment on the exchange rate?

    Fatih Özatay, PhD25 August 2011 - Okunma Sayısı: 794


    In periods when risk appetite decreases, central bank officials should not comment on the exchange rate.

    I have been arguing that in the current climate of high uncertainties, it was not correct for central bank officials to comment and speculate on the exchange rate and that it was even worse to imply a certain level of exchange rate.  I have written commentaries telling why I believe so this week. Since the issue is highly important concerning monetary policy, digging deeper might be useful. Today, I want to address the issue with reference to when it is and it is not wrong to comment. Therefore, I evidently do not argue that central bank officials should never comment on exchange rate. There might be periods when talking about the exchange rate might be harmless. However, monetary policy officials have to be clear about when they should not comment on the rate. Otherwise, they might find themselves in dangerous waters.

    Fall in risk appetite

    When it is wrong to comment on the exchange rate? The answer to this question is clear: In periods when risk appetite of financial investors  decrease and they tend to sail to safe waters, central bank officials should not comment on the exchange rate, let alone implying any level for the rate. Financial investors' sailing to safe waters means that they channel investments towards the state bonds of risk-free countries.  Therefore, they try to sell off the financial assets of risky countries depending on the country's position on the scale of "confidence". The currency obtained is exchanged with foreign exchange (FX) and used to buy the bonds of risk-free countries. In the end, exchange rate increases in the countries where the outflow is observed. Therefore, the main cause of the rise in exchange rate is this outflow, if a fall in global risk appetite is observed.

    If you are unhappy with the upwards trend of the exchange rate, you have to find an answer to this question: what can I do to tackle the fall in risk appetite? The underlying cause of this fall might be global as it the case now. Let me assess the issue for Turkey. What can the Central Bank of Turkey (CBT) do? Evidently, there is fundamentally nothing it can do. Will it eliminate the problems of the European Union? Or will it push the US economy into recession again? Obviously not. However, there are steps the CBT can take steps to ease the problems regarding the fall in FX liquidity caused by a possible decrease in risk appetite: easing repurchase lending to banks, carrying out regular FX auctions to sell FX, reducing reserve requirements for FX deposits. The CBT has to do these. But evidently, this is not my main focus. If you are not able control the underlying cause (the fall in risk appetite) of your problem (the increase in the exchange rate), there is nothing you can do about it. This is as clear as a day. All you can do is to make effort to limit the negative repercussions the problem might cause (like trying to inject FX liquidity to the market).

    No level should be stated

    The fall in risk appetite might have domestic causes, too. Maybe there is nothing wrong with the global economics while the risk appetite against your economy has grown. What you have to do is the same: you have to identify the underlying causes of the rise in the risk appetite. If you do not have the chance to eliminate those, you have to take liquidity measures and again avoid commenting on the exchange rate. For instance, if the risk perception that increased because of the undisciplined fiscal policy has been triggering the demand for FX, the CBT cannot remedy the problem. It can only warn the government in the context of the applicable legal framework. If necessary, you can warn the public with a proper language. However, you cannot state that the exchange rate must be at a certain level since that will then be an "earned" level. So, shouldn't officials talk at all about the exchange rate? Of course they can talk. But let me answer this question later.


    This commentary was published in Radikal daily on 25.08.2011