High FX open position is an economic disease: the economy is indebted in FX terms.

During the last two pieces, I focused on the challenges facing economies whose FX debt is higher than FX assets (that is economies with high FX open position). The latest piece was about the positive and negative effects of real depreciation of the domestic currency, that is, a rise in the exchange rate beyond the difference between domestic and foreign inflation rate. The last one of these is quite interesting as it gives way to a self-feeding upwards pressure on FX open position: domestic currency being valued, especially for a long timeframe, encourages FX borrowings, which in the end increases the FX open position of the economy.

In a nutshell, high FX open position is an economic disease: the economy is indebted in FX terms. Therefore, even if there are no domestic developments that disturb financial markets, foreign tensions affect the economy. Volatility of international risk appetite causes volatility in domestic financial markets. If international volatility strengthens, the damage on the economy intensifies, as was the case in Turkey between the late 2008 and mid-2009. There is more. Even if international outlook is stable, economy policy options will be restricted.  Monetary policy implementation process will be impeded in particular. Here are some examples:

Assume that the monetary authority implements an anti-inflationary policy together with measures that regard the real value of domestic currency in order to maintain the international competitiveness of the economy. Suppose that the monetary authority identified that the domestic currency is overvalued in real terms and decided to increase the exchange rate over an extended timeframe, as the Central Bank of Turkey did in the late 2010. Exchange rate must increase at a rate higher than the difference between domestic and foreign inflation so that the intervention can improve the competitiveness which was eroded.

The first option of the central bank would be as follows: an anti-inflationary monetary policy regime – say inflation targeting – responds to two “differences”: that between actual and targeted inflation and that between actual and potential level of output. The response is delivered via the interest rate policy.  A monetary policy that regards the real value of domestic currency differs from one that does not in that the response should be smaller if interest rates need to be raised and larger if interest rates need to be cut. If the central bank has chosen this option, it has to hope that international financial markets do not face any crisis risk, that prices of public goods and services do not hike unexpectedly due to tax raises or similar interventions, and that energy prices do not escalate.

All of these, as can be noted, will push inflation up, whereas the monetary policy is swinging on a knife-edge balance between inflation and exchange rate. If one of the above takes place or more, an “severe” hike in inflation will be observed, just was the case in Turkey in the second half of 2001. Furthermore, such development might put into question the monetary policy in place and erode the credibility of the central bank in question. The bank might have to introduce policies in the opposite direction. Just as in the case in Turkey between the late 2011 and early 2012. If the first risk, that is, turmoil in international financial markets, is realized, rapid increases in exchange rate will disrupt balance sheets due to the FX open position. This will hence lower growth.

This commentary was published in Radikal daily on 19.03.2013

The second risk also has similar consequences which I will address on Thursday.