Monday, July 12, 2010

Weekly Hurriyet Column: Turkey’s (un)holy trinity

Below is the unedited version of my column for this week. You can read the final version at the Daily News website, but since I have been editing my columns myself on the Daily News website since March, you won't see much of a difference between the two. I opted for a religious reference for the title this time around.

As for the column, because of the strict 3700-character limit, I was not able get into everything I wanted to discuss. In particular, I wanted to summarize the exchange rate discussion in the international context as well as discuss the most sensible solution to the exchange rate problem so far. But since I am in a hurry and really hungry, those will have to wait for the addendum later today.
Whenever Turkish exports falter, exporters and their sidekicks from the academy and media (academedia for short) begin to whine about the exchange rate.

It is an entirely different question whether the exchange rate is to blame for the country’s trade deficit and the high import content of exports - one which was addressed at a conference organized by the Central Bank of Turkey, or CBT, back in November. Instead, I would like to discuss whether the exchange rate is really overvalued and what, if anything, can the Bank do about it.

But which exchange rate should we be talking about? The most obvious choice is the nominal exchange rate, weighed by the size of Turkey’s trade with its trading partners. However, what matters for competitiveness is not the nominal, but the real exchange rate, which is simply the nominal exchange rate adjusted by price differentials. Intuitively, the real exchange rate compares prices of a basket of goods in different countries.

A new index…

Although it is possible to come up with simple measures of the real exchange rate such as The Economist’sBig Mac Index , a complete index is rather laborious. Fortunately, the CBT has been preparing such indices for some time, and it recently revised its methodology.
The first result that stands out is that the new indices point to less overvaluation than before. And to quell accusations of data manipulation, the CBT has published an accompanying paper on the methodology, earning high marks for transparency as well.
The CBT has also started to publish separate developing and developed country-based indices. These show that overvaluation is less evident in comparison to developing countries, which are Turkey’s main export competitors. A brand-new index based on unit labor costs, a better measure for comparing costs across countries, points to a favorable post-Lehman real exchange rate.
Moreover, once you decompose the change in the indices into the nominal exchange rate and the inflation differential between Turkey and the rest of the world, it becomes clear that most of the recent upward trend in the real exchange rate is due to the inflation differential. So exporters should think twice before criticizing monetary policy, less they want to risk shooting themselves in the leg.
All this is not to say that the real exchange rate is undervalued. On the contrary, different methodologies such as its long-run trend, the external financing outlook and macroeconomic theory all point at overvaluation. But the new indices do suggest that the overvaluation is not as large as often claimed, especially when making the right comparisons.

… But the same ancient mindset

Even if the exchange rate were to blame, at least partially, for the country’s export woes, the most-common solution suggested by the whiners, that the CBT should manage the exchange rate, simply would not work in context of inflation targeting and the absence of capital controls- this is the impossible trinity of international macroeconomics.

This is why learned critiques have started to discuss limiting capital controls and even dispense with inflation targeting altogether. While there are some merits to some of their points, their arguments are also extremely short-sighted and asymmetric. For one thing, they ignore the theoretical underpinnings of the overvaluation based on growth and productivity differentials. They also never mention the benefits of a strong lira such as low exchange rate pass-through to inflation and a growing services sector. A balanced discussion needs to involve these factors as well.

But Turkey’s unholy trinity of exporters and academedia will continue their attacks, as balance is the last thing on their minds.

Emre Deliveli is a freelance consultant and columnist for Hurriyet Daily News & Economic Review and Forbes as well as a contributor to Roubini Global Economics. Read his economics blog at

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