Monday, March 9, 2009

Weekly Hurriyet Column: The curious case of the “resilient” lira

Below is the unedited version of my column for this week. You can read the final version at Hurriyet's authors archive . In retrospect, we now (as of April 23) know that there was no repatriation effect at all...

Top-grossing movies, or columns for that matter, deserve sequels. As my mid-February foray into bonds got the most reader responses so far (after disqualifying the hate mails to the political connections piece of two weeks ago), it is only appropriate that I repeat a similar exercise for the lira. Of course, the fact that it is one of the most popular conversation topics of the past few days is an added bonus.

The sharp weakening in the lira last week brought all sorts of skeletons out: Even though the political agenda was quite light for Turkish standards, some put the blame on the politics. Others were quick to jump on the remarks by TUSIAD and Central Bank presidents on the dire straits of the economy. But maybe everyone was looking in the wrong cupboard after all: The secret to the lira may be not lie in last week’s weakness, but in its relative strength before that.

In fact, lira’s resiliency has been the main economic puzzle of 2009 for me so far, not only because the currency had been performing better than peers, but also I was being less and less convinced of a sound rationale for its strength. It is true that Turkey does not share many of the woes of the Eastern European countries whose currencies plunged, and the country usually ranks in the middle in standard risk rankings that take into account factors such as the size of the current account deficit, debt to reserves ratio and the financing gap. However, Turkey was also experiencing more outflows than peers for the past few weeks, as data from EPFR Global, an outfit specializing on fund flow data, have been revealing.

The strong pace of outflows, despite repeated analyst assurances on the country’s strength, is an enigma in itself and could be due to forced selling, sort of a repercussion of Turkish markets’ relative size and liquidity when regional funds could not get out of the small markets. But regardless of the reason, contrary to conventional wisdom, flows have not been supportive of the lira, not in an absolute but also a relative sense.

In the past, it would have been the locals who would come to the rescue in times of lira weakness, selling foreign currency. While still present, that cushioning effect has been rather muted so far this year. It is yet to be seen whether locals have switched from profit-taking to wait-and-see, but local support could not have been the whole story.

One “culprit” that fits in nicely with the data is the repatriation amnesty law, which expired last Monday. While government sources have put the funds drawn at USD 7.5-9bn, we do not have the currency breakdown to assess the role it played on the strength of the lira as well as its recent downfall. In that sense, the lira’s moves next week and its performance relative to peers may provide important hints on what lies ahead for the currency.

Repatriation effect or not, I believe that we have not seen the last of lira weakness for a number of reasons. While the familiar Big Mac index and more scientific measures of the real exchange rate do not show a significant misalignment, asset pricing and flow approaches suggest further weakening in the second quarter. Furthermore, I believe that the well-known (and much written about) vulnerabilities of the Turkish economy are not fully appreciated and have therefore yet to be entirely priced in: The economy is to contract much more than the 1-2% currently expected, monetary & fiscal policy are making a dangerous mix and to top, corporate foreign currency needs are likely to increase pressures.

If there is yet to be a trilogy, I fear I will have to call it “The Country Who Cried”. That is one column I hope I will never have to write.

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