Factors that trigger exchange rate hikes will inevitably affect the economic growth and unemployment rate adversely.

The rise in the exchange rate beyond the CPI inflation, that is, the depreciation of the lira in real terms, evidently has a positive effect on exports, unless other elements offset this gain. In the final analysis, growth rate and the real value of domestic currency are closely related where growth rises as the real value of the domestic currency decreases.

But this feature applies for “normal” economies. There are a considerable number of “non-normal” economies in today’s world. In the case of these, depreciation of the domestic currency in real terms might be detrimental for the level of economic activity. Particularly, it might push private investment and consumption expenditures down and threat the financial stability.

“Non-normal” economies are necessarily troubled in all areas. For instance, they might have solid public budgets with substantially low public debt. Their banking systems might be sound. They might enjoy a pleasing growth rate and low real interest rates. In other words, the economy in general might be bright despite some grey areas. For instance, the corporate sector might have a net foreign exchange debt or so.

It is evident that in such an economy, hikes in exchange rate will be detrimental for the entire corporate sector. Of course, companies which have a large share of export revenues in their turnover would be affected positively by a rise in exchange rate. Yet, the aggregate balance sheet of the sector would worsen. Larger and longer the rise in the exchange rate is, severer will be the effects on the balance sheet. This, on the one hand, weakens the investment capability and appetite and on the other hand reduces the market value of individual companies and lowers their access to finance.

This framework does not apply for the banking sector, but the problems of the corporate sector will eventually have an effect on the banking sector. In periods of decreasing volume of economic activity, the share of nonperforming loans in total loans is expected to increase. This causes banks to be more cautious when extending loans, which would further weaken the corporate sector’s access to finance.

The risk of FX debt

On the other hand, with the deepening of challenges facing the corporate sector, consumption as well as investment expenditures are expected to diminish. The simplest explanation is that some companies lay off workers and are generally become “stingy” in wage decisions.

In a nutshell, if the corporate sector as a whole has substantial amounts of FX debt, that economy cannot be considered “normal.” No matter what steps have been taken to solve problems of other sectors, the economy will remain sensitive to developments which push exchange rate up for a long time frame. The success of public finance and the banking sector immunizes the economy against severe concussions. Despite this, however, factors that trigger exchange rate hikes will inevitably affect the economic growth and unemployment rate adversely.

Yes, I am talking about Turkey. I will continue.

This commentary was published in Radikal daily on 14.03.2013