Competitive advantage based on exchange rate proves temporary in the end turning into inflation and fading away shortly.

Consumer price inflation (CPI) figures for July were released yesterday. Annual CPI reached 8.9 percent. The hike in the headline indicator (the l index) is particularly worrisome. The indicator floated within a narrow corridor over the last eight months averaging 5.7 percent while in July it reached 6.1 percent.

From a different perspective, the CPI inflation is 1 percentage point higher than the average since 2006. But the CPI average since 2006 is 3 points above of the inflation target average over the same period. There is yet another link to the chain: even if the inflation targets had been fulfilled, this would not have given us a comparative cost advantage before our rivals in the export market, since their actual inflation rates are already lower than Turkey’s CPI targets.

Looking from the other ends of the chain, Turkey’s inflation targets over the last eight years were not low when compared to its rivals in the export markets. So even if the targets had been met, this would not have brought Turkey a competitive advantage. Second, actual inflation rate on average in the same period was significantly above the target average. Third, currently inflation rate is floating above the average level in the previous seven years.

Evidently this is not good. Turkey somehow fails in reducing inflation permanently to 5 percent level, which is in fact not very low at all. The difference between realized and targeted CPI inflation since 2006 when the explicit inflation targeting regime was launched demonstrates the issue succinctly (Figure 1).

This phenomenon puts Turkey in a disadvantageous position against its rivals in export markets. To increase exports, Turkey tries to raise the exchange rate so that exports become cheaper for importers. However, the share of imported inputs in production is large and higher exchange rate means higher production costs. In short, any increase in exchange rate causes higher inflation. It is a vicious circle.

What is more, this vicious circle might flame an odd economic debate. It might become a common view that those who draw attention to the inflationary effect of exchange rate increases think the level of exchange rate is insignificant for export performance. Definitely, no economist who studied in the field can be of this opinion. The problem is that competitive advantage based on exchange rate proves temporary in the end turning into inflation and fading away shortly.

This commentary was published in Radikal daily on 06.08.2013