The governing party in Turkey has just been re-elected with a comfortable majority of seats in the parliament, ensuring that it will return to power single-handed. Markets breathe a sigh of relief and the Turkish LIra appreciates, reaching a record high against the U.S. dollar. Good news, or bad news?
Obviously good news for financial markets, but what about the real economy? If, as I have argued before, a competitive currency is good for economic growth, what do we make of the exchange-rate appreciation?
What has just happened in Turkey is a common occurrence in emerging markets. Once you open up to capital flows and adopt a floating exchange rate regime, financial markets determine the value of your currency. And the better you are at managing the economy, the more you get "rewarded" with an appreciating currency--except that you would have been far better off without the reward. It is a veritable Catch-22.
There are exceptions of course. Argentina has deliberately avoided monetary policy orthodoxy, and its Central Bank is actively pursuing an undervalued currency (with the help of capital controls, price controls, and some fiscal restraint). China and some other Asian countries are intervening in currency markets to prevent appreciation and are accumulating huge reserves. But neither of these strategies is sustainable.
Is there a way out? I think maintaining a competitive currency under today's rules of the game requires a three pronged approach:
1. A large enough structural fiscal surplus to make room for looser monetary policy. A more competitive real exchange rate requires increased domestic saving relative to investment, and reduced national expenditures relative to income--and hence the need for a surplus.
2. A modified monetary policy framework, which gives explicit role to the value of the currency. The central bank will have to have a view as to what the appropriate range is for the exchange rate, and take action to move it there. This does not imply or require targeting a specific level of the real exchange rate, which would be much harder (if not impossible).
3. The use of tax and prudential instruments to reduce capital inflows and manage foreign-borrowing-led consumption booms (such as deposit requirements a la Chile or increased liquidity requirements on financial intermediaries).
This is a tough menu. But let me know if you have better suggestions.
UPDATE: The day after I wrote this, the TL was hit by the global market sell-off and took a nose dive. Such is the way of international finance.
UPDATE2: Here is a longer version of the argument, written for Project Syndicate.