As is seen from the given figure, where the rise in the real exchange rate means the valuation in Turkish lira, despite the global crisis yet persists, the lira has started to rise against the selected basket of currencies (including the dollar and the euro).
This is contrary to expectations, because there has been a significant decline in the volume of capital inflows since the third quarter of 2008. This would result in a significant decline in the real exchange rate. Moreover, the recent rise in the real exchange rate (or the overvaluation trend of the TL) is also striking in the sense that interest rates in almost every category, such as the central bank's policy rate and the Treasury's borrowing rates, have been radically declining, a process which would lead the real exchange rate to decline as the attractiveness of interest disappears and therefore the Turkish lira would not be demanded so much. This expectation has also not been realized. Finally, the overvaluation of the TL would increase even more in case of an agreement with IMF.
All these developments contradict the ever-lasting argument that a "high interest rate, low exchange rate policy" has been pursued in Turkey in the post-2001 crisis era, which has been working against the competitive dynamics, particularly in the production sectors.
As I discussed in the last article in detail, within the constraints of the Mundell-Fleming model Turkey has targeted inflation for quite understandable reasons and therefore cannot, by definition, target or guarantee a certain exchange rate or limit the amount of capital inflows.
As a result, after the implementation of successive structural reforms in the post-2002 era, the quality of fiscal performance across the major sectors of the economy improved significantly. Turkey also achieved remarkable success towards achieving price stability. In this, the constrained discretion that was given to the Turkish Central Bank, the significant support from the public sector and a surge in overall productivity across the economy were critical factors.
If we go back to the implementation practices of the central bank, we must first note that the average growth rate of 6.8 percent in 2002-2007 is not consistent with the idea of the high interest rate-low exchange rate argument. In our opinion, this growth performance has not been achieved at the expense of the high interest rate-low exchange rate, but in an environment supported by gradually declining interest rates, as shown in the figure given.
Moreover, trends in final private consumption as well as demand for Turkey's exports since 2003 do not support the given view. In fact, the central bank's Private Consumption Index was on the rise from the beginning of 2004, peaking in the first half of 2006. According to the central bank's data, the rises in the Turkey's Private Consumption and Total Investment Expenditure Indices, two components of the private final consumption expenditures, have far surpassed those of other emerging economies.
The central message is that it would be more realistic to consider multiple factors, rather than single-factor explanations in determining the interactions between the level of interest rates and the real exchange rate as well as the amount of foreign capital inflows.
Another part of the high interest rate-low exchange rate argument is related to comparative studies. Many people look at other emerging market economies and compare the real exchange rate and the level of real interest rates that and conclude that "Turkey is pursuing a high interest rate policy." This is a very simplistic and misleading method.
The current level of real interest rates is higher in Turkey than other emerging market economies for several reasons, including the saving-investment gap, the inflationary memory of a particular country (expectations) and a composite index of risk factors that may not always be equal or in the same direction.
Recent data shows once again, and this time more convincingly, that the central bank has not in fact been implementing a high interest rate policy. As it is seen from the given figure, the interest rates were cut by almost 10 points in the course of the last year. If the high interest rate arguments were correct, we would expect the central bank to increase policy rates in order to prevent capital outflow and also motivate inflows due to the fact that the most pressing issue has been the provision of liquidity for the markets (in the case of banks and corporations).
All these facts should be seen as sufficient enough to vindicate the idea that the central bank has focused primarily on fighting inflation and therefore its interest rate decisions were determined accordingly after the 2001 crisis. In 2007 and 2008, as the inflation rate was surging upwards the central bank reacted by increasing the policy rates. However, as the relationship between the exchange rate and inflation (the pass-through effect) was still sensitive at that time, the stabilization of the exchange rates through the interest rate was an indirect benefit in controlling inflationary pressures.
The last point related to the high interest rate argument is that as the inflation rate has been decreasing beyond the central bank's initial targets of 6.5 for 2009, it signals the danger of a recession. That is why the central bank has been radically decreasing its policy rates since the third quarter of 2008.
As these observations are considered together, we can derive the following messages: First, the Turkish Central Bank has not been unresponsive to growth dynamics, as they are closely related to inflation. Second, there has not been any priority on pursuing a high interest rate policy in order to cultivate some other economic results other than containing inflationary pressures.
