Tying up loose ends III: Trade Deficit and the Exchange Rate

A very belated answer to a reader...

I would like to apologize her for the late comment, which got delayed because of the blogger bans of last week and my attempts to overcome them. Anyway, the reader had the following comment about my post on the trade deficit.

I am convinced that the only way Turkey could simultaneously close its huge trade deficit and sustain a high growth rate (and bring down unemployment) is by manipulating its currency to gain a competitive advantage, like China, Korea and Taiwan do and Germany, Japan and some other countries did back when they were developing countries. Why oh why can't we do this? 

That's not very easy to do when both your current and capital account are open. For example, you want to simulate the current account with a weak lira, but end up chasing portfolio investors away... There are smart ways of differentiating between capital flows, as Turkey and South Korea are trying to, with various degrees of success, but at at the end of the day, I feel that playing with the exchange rate is only a temporary solution. On the other hand, reforms that would make exporters more competitive and productive, such cutting down social security premiums and electricity costs, are for the long haul.

It is also questionable to what degree Turkey's exchange rate is prohibitive. For one thing, it is the real, not the nominal exchange rate (i.e. the cost of your goods relative to other countries) that matters for competitiveness. And looking at the real exchange rate reveals two important facts:

First, Turkey's real exchange rate does not look that overvalued compared to its peers, i.e. other emerging markets. As always, a picture is worth more than a thousand words:

Second, once you disintegrate the change in the exchange rate into nominal exchange rate growth and inflation differential between Turkey and the rest of the world, you see that, while the role of the nominal exchange rate cannot be ignored, an inflation in the 4-5 percent range over the long haul would be a big help as well:

So the best way to "manage" the exchange rate: Bring inflation under control!