Dominant currency, foreign trade, and the exchange rate

THE LIRA has almost always been weak since 2013. Lira strength is but a remnant of the past. After the 2001 Crisis when the Dervis-IMF programme was in vogue, and the ‘savings glut’ flooded the globe with cheap dollars, the TRY gained strength. That was the episode between 2003 and 2008. Somehow people were called upon to remember this as if that specific period was a typical one. No, it was not and it is not. Even a simple graphic that shows the trajectories of major EM currencies against the USD after 2013 suffices to demonstrate that the lira is the worst performer among them. There is no way to change this because the underlying economy did not change one iota over the last 7 years or so. Furthermore, FX debt soared. For every single penny that passed across the frontier, the growth equivalent also fell. In other words, the Turkish economy was able to grow, if not through exports via domestic demand and imports, when foreign capital of all sorts poured in. Today even this is not easy. Debt is so pervasive that household indebtedness statistics were discontinued. Corporate debt and short position statistics reveal the trend. After 2008, for only 2010 and 2011 the mechanism I tried to portray worked. It worked at the expense of skyrocketing current account deficit, and the policy mix had to be changed in 2013. Let us see this a bit more in detail.


The trade-weighted real effective exchange rate stood at 126.5 in October 2010. That was the peak. The lira was overvalued in real terms. Today it is 68.5. The graphic displays a trend that lasted almost an entire decade; the TRY has been weakening throughout. Did any of this help in promoting exports? Not at all as visual inspection would reveal: exports are fluctuating according as domestic demand falters or soars, and export markets are favorable or not. In the old, ‘Old School’ New Keynesian arguments dating back to 1980s, and which I was still using some 20-odd years ago, the real exchange rate was a significant argument in export regressions. Mostly the elasticity of imports was about .6 and that of exports .35, but still the real exchange rate was “significant” – whatever that means. So, back in 2005, when the TRY was obviously over-valued, exporters could complain about it and criticize the exchange rate policy. Now, all
of this talk may have lost its meaning. Not only has the import content of exports increased significantly
– so exporters are also importers in a sense – but also international pricing rules may have changed.

Add to this the corporate short position that boomed, and you come up with the argument that no exchange rate depreciation helps in any sense. Actually the corporate short position was only USD 72.3bn days before Lehman Brothers went bankrupt. Today it stands at USD 169.7bn. It had gone up to USD 222.6bn in March 2018. The currency shocks of 2018 and the accompanying recession dried up foreign resources, and Turkish corporates became net debt payers. This is why the corporate short position shrank. Add also the very high pass-through to inflation – still in the vicinity of 15%, and you end up with an interest rate hike/currency weakness and the accompanying inflation and growth cycles. Any currency depreciation translates into economic woes only with no compensating export bonuses and such. Hence, the exchange rate risk is almost every risk combined. The exchange rate embodies and encompasses all economic malaises and structural weaknesses. The rate of interest is also weakly endogenous, but it is partly a policy tool. The exchange rate is not a policy tool, and cannot be.


Recently, Gita Gopinath of the IMF and Harvard, along with her colleagues, summarized their on-going research on the dominant currency paradigm. Accordingly, non-commodity termsof-trade are uncorrelated with exchange rates. This is extremely important because it wipes away a good part of the currency war-type arguments. Again, it appears like the dollar exchange rate is a lot more important than the bilateral exchange rate with the trade partner country. Hence, in a cross-section the trade weighted
exchange rates may not be as significant as they have been thought before. The inflationary exchange rate pass-through is also dominated by the dollar exchange rate alone. Trade elasticity regressions are also to be re-run to the extent the share of imports invoiced in dollars increases. The authors divide the world into two parts: the dollar country (U.S.) and the rest of the world. The country that issues the dominant currency (USD) is almost insulated from bilateral exchange rates in trade, but the rest of the world is not. That also has a bearing on the rationalizability of the trade war with China. Finally, a dollar appreciation causes a decline in trade volumes among the rest of the world countries – and this is independent of the global business cycle. So, it is the dollar index that we ought to look at even when we search for trade elasticity and volume effects of the exchange rate. No wonder why many countries have been talking about a trading regime that by-passes the USD. But no one is there yet.


So, we still are where we were. First, enter cross-border inflows. In the aftermath of Lehman, emerging countries continued to tap debt markets, but with great difficulty. The decline in the non-core liabilities of emerging economy banking systems was mainly demand-driven as industrial productions and GDPs came crushing down immediately in October 2008; simply there was no demand for credit. However, this decline was also due to the pervasive uncertainty clouding the world economy: risk premiums increased everywhere. In the second phase, however, developed economies resorted to quantitative easing and committed themselves to near-zero interest rates, which jump-started the flow of funds towards emerging markets. As a result, new credit booms occurred and non-core liabilities grew by leaps and bounds. In the case of Turkey, the new course meant two things. First, equity capital began to grow at a rate that is 15% higher than its pre-Lehman trend and kept this steady course for many years after 2009. The reason was twofold: the policy rate was cut from 16.5% all the way down to 6.5%, which implied considerable capital gains for Turkish banks. Then the rising NPLs were not allowed to wipe out net profits since the BRSA (Banking Regulation and Supervision Agency) had cut the reserve requirement rate to 1% or TRY loans and to 2% for FX-denominated loans for an initial period of three months – which was extended. At the going rate, the banks were covering for 80% of non-performing loans. That made a huge difference. Second, banks foreign funding increased from c. 5% of total liabilities to c. 22% within the first post-Lehman five years. Access to debt markets was quasi-automatic, and both corporate and banking sector debt increased rapidly. Emerging market corporate debt became popular. The London money market was awash with corporate credit. Cheap and easy money caused a domestic-demand driven growth path for at least two consecutive years. In a way, it continued even after 2013, albeit at a much lower pace. It may not continue in 2020 and in 2021, even at a much lower pace. But then who needs a higher pace? After all, we are only talking about a mild recovery based on business cycle frequency supported by loan growth, right? A 3% GDP growth rate is nothing for Turkey; it comes quasi-automatically given c. 85 million residents, always buoyant domestic demand given access to credit, and so on. It won’t happen again in the sense that an exact replication of the old story for an extended period is out of question.

This is why I have touched upon the possibility of early elections over the last month or so. As TRY rates were repressed to negative territory, demand for FX soared and asset substitution (dollarization) gained further momentum. Now dollarization is as deeply rooted and widespread a phenomenon as it was 20 years ago. Individuals qua households, not only firms, and at very low magnitudes at that, buy dollars and gold if only to protect their money against inflation. As the graphic depicts, lira weakness dates back to 2013, after which time it depreciated trend-wise.


Time is of the essence, but still there may be a few months left before deciding what radical and comprehensive course of action to take. Growth will be automatically curtailed to the extent that a hard landing is in the cards unless the rate of interest acts as an equilibrating device. By how much must it be hiked? The market will point to that. That said, the so-called market forces are asically residents now. Still the benchmark T-bill secondary and auction rates, even as such, tell us about the first and minimal level in order to shore up some kind of equilibrium.

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