The exchange rate regime almost becomes a pre-determined fixed-growth exchange rate regime.

Before the latest shower of data, I was talking about a severe economic illness which many countries suffer. I referred to economies that have higher consolidated FX liabilities in comparison with their FX earnings. Economies that could not have completely normalized, in other words. Turkey is among these. In such economies, makers and executers of economic policy face a fundamental dilemma. But first, there are two points I want to stress.

First, in the short-term, exchange rate below inflation rate (appreciation of domestic currency in real terms) might have stronger positive than negative effects. Within a longer timeframe, however, appreciation of the currency in real terms starts to affect the economy adversely. It weakens competitiveness, encourages FX borrowing from abroad. At the end of the day, the economy shifts to a higher FX open position. In a sense, the open position feeds itself, automatically giving way to escalating the open position. Hence, economic management wants neither appreciation nor depreciation in real terms.

Second, the FX open position turns exchange rate into a critical variable. The more volatile exchange rate is, the harder it becomes to plan the future due to rising uncertainties. Therefore, central banks try to limit the volatility when other circumstances permit.

The dilemma here is about controlling the two at the same time. Central banks, on the one hand, try to keep real exchange rate at a certain level. Here is a rough estimate: between 2009 to the date, average inflation in Turkey was 7.5 percent. Assume that average inflation in the EU and in the US over this period were near the long-term average, at 2 percent. The difference is then 5.5 percent. Let’s leave out Turkey’s rivals for the sake of simplicity. In order to maintain the real value of the lira, exchange rate has to increase on average by 5.5 percent annually. If the monetary policy has a focus on real exchange rate, it can determine how much to increase the exchange rate, of course on a more complicated analysis.

On the other hand, here is the deal if the bank aims also to reduce the exchange rate volatility: the bank can calculate the average annual rise in exchange rate, that is, the exchange rate trend. Of course, there will be deviations, but the bank takes into account the ups and downs around the trend line: if it moves down constantly, the currency will appreciate in real terms and vice versa, while, the economic management wants neither one of the options. In addition, the banks want to limit the deviation, that is, the volatility.

Hence, the exchange rate regime almost becomes a pre-determined fixed-growth exchange rate regime. This is convenient particularly for short-term capital inflows as investors are able to roughly estimate what the exchange rate will be when they exit the market. The exchange rate risk for investors almost disappears. Also for the same reason, it promotes borrowing from abroad. At the end of the day, the disease becomes severer, as the latest statistics for Turkey also signify. I will continue.

This commentary was published in Radikal daily on 13.04.2013