Konjonktur

The Economy And The Exchange Rate

March was an interesting month in terms of changes in the foreign exchange rate. When the dollar exchange rate dipped below YTL 1.3 during the first half of the month everybody began to ask: “I wonder how far it will fall?” But everything went into reverse during the second half of the month. As the result of developments in the rest of the world, the dollar started heading in the opposite direction. This resulted in people asking: “I wonder how far it will rise?”

It is not for nothing that the changes in the foreign exchange rates are followed with such great interest by those involved in the economy. Changes in the foreign exchange rate have an impact on several economic variables. The changes that occur in these economic variables as a result of the foreign exchange rate in the end effect our standard of living.

The impact of the foreign exchange rate on the economy

The best known impact of the foreign exchange rate is on foreign trade. In theory, when the foreign exchange rate increases then exports rise and imports fall and the balance of foreign trade is affected positively. When the foreign exchange rate falls, exports decline and imports become more attractive, which has a negative impact on the balance of foreign trade. For this reason exporters always want the foreign exchange rate to rise. Importers, even if they do not say so openly, prefer the opposite so as to enable them to do more business.

It is very simple to explain the impact of the foreign exchange rate on foreign trade. An increase in the foreign exchange rate means that, in foreign exchange terms, export goods become cheaper and, in YTL terms, import goods become more expensive. When the foreign exchange rate falls, the prices of export goods rise in foreign exchange terms, and the YTL prices of imported goods fall. These changes in price affect demand and have an effect on the volume of goods that are exported or imported.

Changes in the exchange rate have an important impact on inflation. As noted above, changes in the foreign exchange rate have an effect on the YTL prices of imported goods. Changes in the prices of imported consumer goods have a direct impact on inflation. Changes in the prices of imported raw materials and semi-finished goods have an indirect impact on inflation by affecting business costs.

There are also virtual effects

Changes in the foreign exchange rate affect investors’ portfolio preferences and have an impact on the stock market indices and interest rates. These impacts, which occur on the money markets on a daily basis, attract greater interest. When these effects are only temporary, they do not from an economic perspective have an important impact on the foreign trade balance or the rate of inflation. But if there is a permanent change in interest rates in particular then this most certainly affects the economy.

Some of the effects that changes in the exchange rate have on the economy are virtual. If the impact of these virtual effects is confined to morale then they do not mean anything in real terms. For example, this kind of impact can be seen in per capital national income figures calculated in foreign currency. When the foreign exchange rate does not change or falls, if per capita national income is calculated in dollars, then it increases at a higher rate than the real increase. When the foreign exchange rate rises by more than inflation then per capital national income rises by less than the real increase in national income.

Almost impossible to predict

The effects that changes in the foreign exchange rate have on the economy means that the question that economists are most frequently asked is: “What will the dollar exchange rate be?” Ever since Turkey moved to a floating exchange rate, this question has become almost impossible to answer and it is one that wearies even the most experienced economist.

Before February 2001, when the Central Bank was trying to peg the foreign exchange rate to the rate of inflation, it was very easy to answer this question. At the time, the foreign exchange rate used to rise or fall in line with inflation. As inflation had reached -- and become fixed at -- a certain plateau it was not difficult to predict both the inflation rate and the foreign exchange rate.

But since Turkey has moved to the floating exchange rate system it has become almost impossible to predict changes in the foreign exchange rate. For this reason, even the government is no longer setting a target for the inflation rate. It does estimate the exchange rate in order to determine its other economic targets but this estimate does not have any meaning as an economic indicator. In any case, over the last three years this estimate has never been accurate.

The government has made its calculations for 2005 according to a dollar exchange rate of YTL 1.6. But in the first quarter of the year the dollar exchange rate came nowhere near this figure. Unless there is a crisis in the months to come, the government’s forecast for the foreign exchange rate will again be inaccurate.

According to the Central Bank’s Survey of Expectations, which it holds twice every month, the average forecast by experts from the real and financial sectors for the year-end dollar exchange rate is still YTL 1.43. But these experts’ forecasts are continually changing in line with developments on the markets. Three months ago these experts forecast that the year end dollar exchange rate would be YTL 1.52. As a result, it does not look as if it would be wise to place too much faith in these forecasts about the future foreign exchange rate.

The future of the exchange rate.

In the months ahead, the foreign exchange rate will fluctuate in response to developments both inside and outside the country. The domestic influences will include steps taken in relation to the agreement with the IMF and membership of the EU and the most influential external effects will be developments in the US economy and the decisions of the Fed (the US Central Bank) on interest rates.

When the current situation and expectations for the near future are taken into consideration, we can see that the foreign exchange markets may fluctuate during the spring months.

Let’s look at the external developments which were the reason for the fluctuations which began last month. These fluctuations began before the FED held its meeting on 22 March and continued afterwards. Expectations that the FED would pursue an aggressive interest rate cut meant that international investors withdrew from developing markets such as Turkey and began to prepare to turn towards the US.

At that meeting the FED raised interest rates by 0.25 percent, in line with the more moderate expectations, but the statements that were made afterwards confused everybody. The fact that the FED had begun to worry about inflation gave the impression that interest rates would continue to rise through the rest of the year. But it was not clear whether the increases in interest rates would be large or small. The FED will hold its next meeting on 3 May. People will continue to be confused until at least that date and it does not look as if the markets will settle down.

One should take precautions before the storm strikes

When one looks at internal developments, the situation is uncertain. There is still no sign of the new Stand-by agreement which was expected to come into force in February. The government is delaying passing the laws which the IMF has set as preconditions for the agreement. Something needs to done to solve the Cyprus problem in order for accession negotiations to begin with the EU on 3 October. There has still been no real development in this direction.

As the financial markets remain upbeat, they have still not reacted. But if the government does not take any measures on these two issues during April, then the situation could change.

The government cannot control developments outside Turkey. Whatever the government does, if there are fluctuations on the global markets, then there will also be fluctuations on foreign exchange markets in Turkey. But if progress is made with the IMF or the EU, the strength of this volatility may be less. If this does not happen, the fluctuations can turn into a storm.

INDUSTRY’S WINTER REPORT

After growing very rapidly in the first half of last year, the pace of growth in industry slowed considerably in the second half of the year. Bearing in mind the weakness of domestic demand, economists expected this slowdown to continue in the first half of 2005. The low January capacity utilization rate was an indication of this.

But the State Institute of Statistics (SIS) figures for the rate of growth in industrial production in January were much higher than we had expected. Growth had been forecast to be 2.5-3 percent. But the actual figure was 6.8 percent.

Sectors which produce for export or produce investment goods, semi-finished goods and raw materials made a significant contribution to the rate of industrial production being higher than expected in January. Sectors which produce investment goods, semi-finished goods and raw materials are dependent on orders from other sectors, which suggests that the increase in industrial production will continue in the months ahead. The fact that there is still no sign of any slowdown in exports means that we are positive about the future of industrial production.

The capacity utilization rate in February was lower than in January. But, even if it was only by a small margin, the rate of capacity utilization in February was still higher than in the same month the previous year. Even though the rate of capacity utilization was low, industrial production may still have increased in February.

With the exception of January, industrial output rose by double digits in every month in the first half of last year. Of course, it would be difficult for industrial production to grow by the same rate this year. But industrial performance currently looks better than in the final months of last year. This suggests that there is chance that the economy will achieve the target growth rate of 5 percent.

EXPECTATIONS AHEAD OF TARGETS

The fact that the economy began 2005 better than expected has had a positive impact on expectations for the year-end figures. Most of the forecasts in the Central Banks’ twice monthly Survey of Expectations are currently more positive than the government targets.

In formulating its Survey of Expectations, the Central Bank consults with experts from the financial and real sectors and one of the indicators in which there is most interest is the forecast for year-end inflation. In the first survey conducted in January the forecast for year-end inflation was 8.4 percent. In February the expectations for inflation had fallen to match the government targets. The fact that inflation was lower than expected in the first two months of the year means that in March expectations for inflation were lower than the government target.

The Central Bank describes the difference between expectations for inflation and the government targets as the ‘credibility deficit’. The fact that expectations for inflation are currently lower than the target means that there is a credibility surplus. Underpinning this credibility surplus is that fact that over the last three years inflation has always been lower than the government target. There is a similar credibility surplus in regard to the Gross National Product (GNP) growth rate. The government target for growth is 5 percent, while expectations are for 5.5 percent.

The fact that the YTL began 2005 by appreciating meant that until the second survey in March expectations for the year-end dollar exchange kept falling. The appreciation of the dollar from mid-March onwards meant that in the second survey the expectations for year-end rose a little.

There has been a deterioration in expectations for the year-end current account. In the first survey conducted in January the expectation for the current account deficit was $12.5 billion. In the surveys conducted in March the expectations for the current account deficit were $14.9 billion.