For Mr. Başçı's expectations to prove right, the Fed has to continue the monetary expansion and the European economy has to recover.

I learned about the speech the Central Bank (CBT) Governor Erdem Başçı delivered in Bursa after I was requested to state my opinions from by two different newspapers. Then I read an extended review of the speech on the CBT website. Two points Başçı emphasized attracts attention. First, he said, “2012 will be a year in which the Turkish lira is one of the currencies that strengthens the most.” Second, he maintained that the high current account deficit that Turkey has been suffering for the last couple of years stemmed from the abundant and cheap sources of finance (if the summaries were correct of course). He made this point to stress that the argument that overvalued lira was the cause of the current account deficit was wrong.

Let me state first that I agree with Mr. Başçı about his remarks on the high current account deficit phenomenon. I have argued this several times before at this column, as well. After the global crisis, central banks of the developed world issued high amounts of currency and lowered interest rates to historic lows. This excess liquidity flew towards countries like Turkey which had a relatively stronger economic state and also promised higher returns on investment. In the end, domestic currency appreciated and rapid credit expansion was observed in such countries, both of which caused an upwards pressure on current account deficit. In fact, Turkey was chief among countries which faced the largest credit expansion and highest current account deficit during the mentioned period.

As a natural result, monetary authorities of peer countries embarked on a search to limit the rapid credit expansion that stemmed from strong fund inflows that might end as rapidly as it emerged. The CBT was among those, as well. There is nothing wrong up to here. As I have talked about this several times before, I will not repeat my arguments. In a nutshell, the CBT could have come up with a solution only by strengthening the policy tools under inflation targeting regime in cooperation with the Banking Regulation and Supervision Agency. Instead, a complicated path was chosen. What I object in the first place is this complicity that might harm the credibility of monetary policy. In order for Mr. Başçı to be proven right, the following scenario must be realized: first, the Fed must not start raising interest rates and reverse monetary expansion in 2012. The US economy must recover slowly and risk appetite will not decrease due to a US-based action. Second, the circumstances in Europe must not worsen. In addition, the liquidity the European Central Bank has been issuing since late 2011 has to flow towards Turkey and peer countries and risk appetite must not worsen due to a Europe-based reason.

The US part of the scenario will most likely take place. The Europe part, however, is doubtful if possible. If this scenario turns into reality, Mr. Başçı’s remarks can be justified. Moreover, such circumstances would also justify the current interventions in the exchange rate. However, the opposite is more probable. European banks are obliged to generate additional capital at the amount of €115 billion or reduce their balances accordingly. Furthermore, they are facing difficulty in repaying the debt borrowed via the sale of bonds at large amounts. Should these problems strengthen, capital inflows towards Turkey and peer countries might be hindered, which could depreciate the Lira further.

This commentary was published in Radikal daily on 07.01.2012