Due to the FX open position of the economy, rapid increases in exchange rate would disrupt balance sheets and hence lower growth.

I will continue with the challenges facing economies that have higher FX liabilities compared to FX debt. This economic disease restricts policy options. For instance, assume that the central bank 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.

The first option of the central bank would be to implement a monetary policy that regards the real value of domestic currency. 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 developments would push inflation up. In addition, due to the FX open position of the economy, rapid increases in exchange rate would disrupt balance sheets and hence lower growth.

The Central Bank of Turkey (CB) implemented this policy starting in the late 2010 during the first eight months of 2011. Unfortunately, what we have most feared happened: in the autumn of 2011, international financial markets were dragged into turmoil due to the developments in Europe. As a result, exchange rate and interest rate hiked in Turkey. International risk appetite decreased. Inflation that was on the rise due to the CB policy in place increased further and growth rate started to decline.

The second policy option would be that the central bank targets the real value of the currency indirectly. For instance, as in the classical inflation targeting, the bank focuses on the difference between actual and targeted inflation, and actual and potential level of output. The bank knows that if inflation is on track, it will cut interest rates, which will prevent the appreciation of domestic currency in real terms at some level depending on the circumstances. Therefore, it will indirectly safeguard the international competitiveness of the economy. The difference between the two options is: In the former the interest rate response is given in advance and will be above that implied by the inflation rate and output level. In the latter, interest rate is set in line with the inflation and output level upon the realization that if things are on track, real exchange rate will be controlled indirectly.

There is no difference between the two options concerning the developments that disturb the outlook. The central bank has to hope that the three adverse developments mentioned above do not take place. However, in the second option the bank does not undertake any risks of damaging the reputation of monetary policy. In the case of the first option, if the price of public goods and services are increased contrary to the central bank’s assumptions for instance, the reputation of the monetary policy would be damaged. In addition, if the central bank pursues the second option and successfully explains the interest rate policy to economic agents, it can even reduce the probability of price raises.

Both of the differences were in favor of the second policy option. There is one in support of the first: it involves steps to strengthen the competitiveness of the economy in substitution of structural reforms which yield results in the medium-long term. It thus limits the pressure on monetary policy. Of course there are other constraints FX open position puts on the economic policy. I will continue addressing these.

This commentary was published in Radikal daily on 21.03.2013