When good news for markets is bad news for the economy

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.

Comments

[paine]

dani r :

"This is a tough menu. But let me know if you have better suggestions"

tough ain't the word for it

it requires
"internal political organization"
not often
"compatible"
with most western
agit prop
cartoon models
of an "open" society

since
its all built on getting
to where
your point two
can "happen"

if your point one
is
necessary
to get to point two

ugh

your iron
vice
on levels
of social consumption
implies
either mass stringency
or a
clamp down
on your wealth elites "life styles"
and more specifically
their near feudal gigs
( large land
and petty loan
"rent streams "....)

you'll need
a heavy state apparatus
with a long clear road ahead of it

lets recap and add more ogre like stuff:

your point two can be
the product
of your point one
but with a proviso

pt one yields
the potential
thru pt two
"done right "
to induce faster growth
errrrr...
so long as
point three blocks
the el destructo effect
of the inevitable
blow in / blow out
north south
capital waves
which indeed
also can blow apart any real exchange rate control plan

but to get
to pareto improve
real forex
by
" controls"
on your
inflow out flow
capital markets
requires
a "mighty national state "
able to withstand
the domestic wealth elites
and
the ire of
the traditional
middle people too

let me put it this way

political elections
would need to be
state "control-able"
for some good long time too
to paraphrase one of my hero's

if the people
end up
not liking
the tough course
of the real exchange rate regime
the state would
need to be able to appoint a new people
or at least ignore
the one in place

[paine]

dr:

"neither of these strategies is sustainable"

do you mean
it burst from "internal pressures ...eventually ??

even so i doubt
the wage class
of industrial america
can "afford"
to wait it out in china's case

folks have been predicting
the great reval levy
of china to over flow
its banks
for some time now

i'm forced to ask:

what hidden law of national economy
are you basing this insight on ???
if its not time scaled
if its just
some "the day will come "
inevitable end point
i wouldn't find
much solice in it

[Marius]

If you aim for a higher than normal fiscal surplus with the explicit goal of lowering interest rates and 'undervalueing' your currency to boost exports, are you not in fact promoting a very complicated method to use taxes for export subsidies (or at least sell products 'on credit'?

Will the net effect not be very similar to the Asian method of active controls? In that method the government itself invests in foreign currencies, in your proposal the government increases the money available to internal investors, while tweaking all available options to encourage them to invest that money abroad.

Will this not be exactly as sustainable/unsustainable as the 'Asian option'? The country as a whole will still have the same huge reserves. The market might turn out to be a better investor, but on the other hand the Asian countries can use there direct investment policy for leverage in international politics.

I suppose I am missing something.

[Salih]

Thank you Sir.

[Nurhisham Hussein]

I'd say point (1) is an initial condition, not something that has to be continuously maintained. In fact, it might not even be necessary if national savings are already high enough.

You can further mandate increased national savings through compulsory pension contributions for instance; see: Singapore's Compulsory Provident Fund (CPF) or Malaysia's Employees Provident Fund (EPF) - 25% of my nominal wage is deducted straight into EPF.

[Marcos]

It makes sense, but I am not fully convinced this would apply to Turkey. Good for the market in this case may be good for the economy. Turkey needs growth, but it also needs stability and the second one is still dependent on market confidence. The market may be rewarding Turkey now, but these are very benign global liquidity conditions. Under a more difficult credit market Turkey has enough hotspots that could trigger a rapid change in perceptions in the market. (political identity crisis, energy dependency, kurds, Iraq, EU/cyprus etc). Turkey is also in the eyes of the market one of the very few classic high debt emerging markets today, which means that it gets hit by sell-offs a lot harder than other EMs. So the country may be better off keeping the currency strong for some time to clean up debt structure on the cheap "a la Brasil". Keeping the currency undervalued in this case may mean too high a fiscal cost and may come to threaten stability. Now solid prudential regulations are always a good idea. But while the heavy private sector external borrowing may look like it needs adult supervision, it's there for a reason. And it may have less to do with the fiscal accounts then with the lack of private domestic savings. So "solid" regulations in this case would have less to do with liquidity requirements overall but more with encouraging domestic savings. These would have to be coupled with policies to further develop domestic captial markets and institutional investors.

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I'd say point (1) is an initial condition, not something that has to be continuously maintained. In fact, it might not even be necessary if national savings are already high enough.

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