Monday, October 27, 2008

USDTRY: From parity to 2:1

Back in my days as a bank Treasury economist, I used to provide forecasts for the important Turkish macro variables to the trading and sales teams. While my forecasts for inflation, current account and the like were usually well-heeded, I can't say the same for my FX (USDTRY) and Tbill (benchmark) forecasts. In early 2008, my seemingly bearish view on USDTRY and the benchmark was sharply in contrast to the traders' (and the market's) bullish view and had become a major source of jokes (along with my losing streak of Besiktas bets- mind you, this was shortly after the losses to Liverpool and Ezikbahce).

In fact, the Treasury's lack of confidence in my asset price forecasts made perfect sense. After all, as a market economist for a little bit over a year, I was still getting acquainted with the workings of markets. Besides, there is theoretical and empirical support that exchange and interest rates cannot be forecasted over short periods of time, and for this reason, I myself wasn't eager to provide forecasts on USDTRY and the benchmark either. Still, I did the best I could, but I just could not get my analysis in line with the bullish view prevalent in the market.

I used time series models, asset pricing models and open economy macro models. I even calculated the equilibrium real exchange in six ways. Whatever I did, TRY always seemed overvalued and USDTRY always seemed poised for an upward move. At the time, the leading sentiment in our Treasury (and in the markets in general) was that USDTRY was heading towards parity, and to counter that I'd jokingly say that it was heading towards 2.

Move forward 8 months, and USDTRY, which had been close to 1.1500 earlier in the year, is now closer to 2:1 than parity. I have to admit that my analytical framework had not captured such worsening of the financial crisis and therefore, most of analyses were spitting out USDTRY in the 1.4000s by year-end. This no way proves that economic analysis is superior to market sentiment; on the contrary, rowing against markets will usually capsize your ship in the short-t0-medium run. But in the long-run, one of two things happen: 1. You die, as Keynes said. 2. If you are not dead, Economics catches up with you. Therefore, I'd still call the move in USDTRY the vindication of Economics against market sentiment.

And worst of all, worse may be yet to come, at least to emerging markets. The Economist asks the trillion-dollar question in its latest issue: What will happen to emerging economies? As much as EM currencies have depreciated, most countries, including Turkey, have not experienced a currency crisis yet. In the current highly uncertain environment, opinion has changed markedly against Turkey, which weathered the storm well early on, in a couple of weeks. The country's well-known vulnerabilities, summarized in the latest issue of the Economist, have turned it to one of the EM perceived to be prone to a crisis. In this vein, Turkish assets, which started the EM shakeover episode as relatively resilient, could see further falls.

With the godfather of currency crises (not Soros, he created one, whereas Krugman invented one, although this fact has been overlooked recently after he got the Nobel Prize for his contributions to trade theory and new economic geography theory ) reporting a likely hard landing in EM in the coming months, we may not be that far off from my USDTRY 2:1 prediction. At least, the parity, as EURUSD is known, is moving towards parity, if this'd be a consolation for market participants. They got the number right, but the currency wrong...

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