The investment grade will most certainly put a downwards pressure on exchange rate and an upwards pressure on the current account deficit.

At the end of the latest commentary, I asked a question that was hard to answer. It was about the direction to which the exchange rate will head. Soon after came two related developments. First, only a couple of hours after I sent the piece to the paper, Fitch declared that Turkey’s rating was upgraded to investment level, making it easier for us to answer the question. Also, the US election was completed; indicating that one factor that obstructs the answer of the question remained the same.

Yes, nothing changed in the US and Obama elected president again. Democrats maintained the majority in the Senate and Republicans preserved their control in the House of Representatives. In other words, the political polarization that has been obstructing important policy decisions prevailed. This perpetuates the risk of implementing wrong policies (budget cuts) at a wrong time (before the economy fully recovered), or the risk of a “fiscal cliff” as commonly known. Automatic tax raises and expenditure cuts on certain items are on the table to be effective starting with the New Year, if the Democrats and the House of Representatives fail to settle the issue of course. Meanwhile, Reuters emphasized that there now were fewer moderates in both parties, which obstructed consensus.

What will the CB do?

So, let’s start with assuming that the problem will be settled with a “middle-way” solution and that risks will be overthrown. Also, assume that things in Europe will not worsen and thus international risk appetite will be strong. Given these conditions, abundant liquidity injected by the US and Europe in escape from low interest rates in the home countries will continue flowing towards countries like Turkey.

Fitch upgrading Turkey’s grade to investment level will further strengthen foreign exchange inflows. An enlightening study by Central Bank researchers İbrahim Burak Kanlı and Yasemin Barlas identifies the economic developments in countries that were upgraded to investment level. According to the study (accessible at the Central Bank’s website – Economic Notes 12/25, 21 September 2012) capital inflows rise significantly after the investment grade. The inflow mainly takes place via portfolio investments and credit channels. As a result, exchange rate and the cost of external finance decrease while terms of borrowing do not change considerably. Also, domestic credit growth gains pace while interest rates on loans decrease; current account balance is disturbed and external debt increases.

Of course each and every of these results will not necessarily be observed in Turkey. But given the external conditions highlighted above and unless the Syria-Turkey relations don’t escalate, investment grade will lead to a rise in external fund inflow towards Turkey, particularly if institutions follow Fitch and upgrade Turkey. This will most certainly put downwards pressure on exchange rate and upwards pressure on the current account deficit.

Within this framework, the steps that the Central Bank will take are of critical importance. In this perspective, it would be useful to assess the interest rate corridor decisions during the period when capital inflows towards Turkey increased significantly (between the late 2010 and August 2011). In addition, please note that the reserve options mechanisms that was not introduced back than will be used actively this time. I will continue on Saturday.

This commentary was published in Radikal daily on 08.11.2012