In the case of turmoil in international financial markets, economies with high FX open position are affected at the highest degree

Last time I argued that real depreciation of the domestic currency, that is, a rise in the exchange rate beyond the difference between domestic and foreign inflation rate, would be detrimental for the level of economic activity. The main feature of such economies is that they have higher FX debt compared to FX receivables. Of course, certain sectors might have higher FX assets than FX liabilities. Exporter companies are in this group, for instance. What matters for the entire economy, however, is the FX liability to asset ratio in the aggregate balance sheet of all sectors. I will call this the FX open position. This is the case for Turkey’s corporate sector today.

Three positive implications

In such an economy, 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.

Real appreciation of domestic currency, on the other hand, has three positive implications for the overall economy: first, with to the FX open position, the aggregate balance sheet of the overall economy improves. Second, the cost of imported inputs diminishes, easing the inflation rate. Third, the central bank gains room to lower interest rates. The first and the last one, as you might have noted, improve the level of economic activity. Enhanced balance sheets and lower interest rates both stimulate investment and consumption. With lower costs, the rise in demand does not necessarily push up inflation rate. Therefore, higher growth rates can be achieved with lower or stable inflation.

Open position increases

There also are negative effects of the real appreciation of domestic currency. The most known is the effect on export and import performance. If exchange rate decreases or increases at a rate below the inflation, this will discourage exports and encourage imports, disturbing the current account balance. Another critical effect is that domestic currency being valued, especially for a long timeframe, encourages FX borrowings. The effect intensifies particularly if domestic savings rate is low. Fund requirements are predominantly met by borrowing from abroad, which in the end increases the FX open position of the economy.

Open position in a way feeds itself, giving way to a higher FX open position in the end. Of course if international markets have an appetite for risk. This is indeed another area of concern: in the case of turmoil in international financial markets, economies with high FX open position are affected at the highest degree. This impedes the economic policy process, the monetary policy process to begin with. I will continue.

This commentary was published in Radikal daily on 16.03.2013