THE TURKISH CURRENT ACCOUNT, REAL EXCHANGE RATE AND SUSTAINABILITY: A METHODOLOGICAL FRAMEWORK

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1 The Journal of Inernaional Trade and Diplomacy 1 (1), Spring 2007: THE TURKISH CURRENT ACCOUNT, REAL EXCHANGE RATE AND SUSTAINABILITY: A METHODOLOGICAL FRAMEWORK Sübidey Togan and Hakan Berumen * I. INTRODUCTION Embarked on an accession pah o he European Union (EU), Turkey needs higher invesmen raios o susain high growh raes for a prolonged period so as o susain convergence wih he EU. In a fas medium-erm growh scenario, pressures on he curren accoun are likely o emerge as invesmen will need o increase while fas income growh will also boos consumpion and impors. However, in he case of Turkey, large curren accoun (CA) deficis are also likely o be combined wih an appreciaing real exchange rae, as in he pas few years, in response o robus capial inflows as Turkey ges closer o EU accession. A convergence play, similar o hose seen in oher EU accession counries and Eurozone members, where expeced declines in domesic ineres raes o levels closer o he EU average generae expecaions of significan capial gains, is likely o make porfolio invesmens o Turkey paricularly aracive. This could inensify pressures on he curren accoun and leave he counry vulnerable o possible swings in marke senimen and capial flow reversals. In his conex, i is imporan o keep he curren accoun defici a susainable levels. During he las hree and half decades Turkey has experienced four balance of paymens crises. These crises highlighed he danger of having excessively large curren accoun deficis which are associaed wih a high probabiliy of a balance of paymens crisis. * Sübidey Togan (ogan@bilken.edu.r) and Hakan Berumen (berumen@bilken.edu.r) are from Bilken Universiy. The auhors are hankful o Arisomene Varoudakis, Şeref Saygılı and paricipans of he conference on Curren Issues in Inernaional Trade and Diplomacy for helpful commens on earlier versions of his paper. Responsibiliy for all he saemens made in his paper belongs o he auhors alone.

2 Sübidey Togan and Hakan Berumen Of course, large curren accoun deficis were no he only cause of hese currency crises. During he periods prior o he crises, curren accoun deficis were financed mainly by shor-erm foreign borrowing. There were also deeper weaknesses in he Turkish economy. The 1994 and 2001 crises occurred when he counry was facing large fiscal deficis, huge public debs, problems in he banking secor, and high inflaion raes. Budge defici, measured by he public secor borrowing requiremens in proporion o he GNP, amouned o 10.9 percen during , and o 10.4 during Inflaion raes during flucuaed beween 54.9 and percen, and he average inflaion rae amouned o 75.2 percen. There were disorions creaed by he sae banks, which had a subsanial share of he banking secor oal asses. These banks faced unrecovered coss from duies carried on behalf of he governmen, and hey covered heir financing needs from markes by borrowing a high ineres raes and shor mauriies. Currency and mauriy mismaches on he balance shees of he banks had lef he public auhoriies lile leeway for using eiher ineres-rae or exchange rae adjusmens o resore balance wihou undermining he sabiliy of he banking secor. In addiion, Turkey lacked, in he banking secor, compeen supervisory auhoriies and a regulaory framework. Thus Turkey before he 2001 crisis had neiher resolved is fiscal problems, nor aained price sabiliy or a sound banking secor. The lessons learned from pas crisis episodes are ha preserving CA susainabiliy requires pruden macroeconomic policies o be in place; a sound banking sysem and srong prudenial supervision; and a srong invesmen climae o arac FDI and oher long-erm capial flows. Srong produciviy growh o offse he impac of real exchange rae appreciaion is imporan o mainain exernal compeiiveness and susaining he curren accoun deficis. In he recen years of very srong growh in Turkey since he 2001 crisis, vulnerabiliies have emerged again because, despie fiscal consolidaion, domesic savings have increasingly fallen shor of domesic invesmen, resuling in a widening 156

3 The Turkish Curren Accoun, Real Exchange Rae And Susainabiliy defici of he exernal curren accoun. Of course, hisory does no necessarily need o repea iself: Thanks o susained reforms since he 2001 crisis, Turkey is now in a much beer posiion o cope wih exernal vulnerabiliies. However, i is imporan ha he susainabiliy of he curren accoun be analyzed under differen growh scenarios and assumpions abou he exernal environmen, so as o design policies conducive o susained growh. The purpose of his paper is o provide a mehodological framework for he analysis of he susainabiliy of he curren accoun in Turkey. The paper is srucured as follows. While Secion 1 considers briefly he macroeconomic developmens during he las few decades emphasizing issues relaed wih he foreign exchange regime followed by he counry during he las few decades, Secion 2 considers empirical deerminaion of expor and impor demand funcions. Secion 3 elaboraes a framework for assessing curren accoun susainabiliy based on hese empirical esimaes and by disinguishing he fundamenal deerminans of foreign deb dynamics. Based on his framework, Secion 4 discusses scenarios for susainabiliy in he coming years. Finally Secion 5 concludes he paper. II. DEVELOPMENTS IN CURRENT ACCOUNT, REAL EXCHANGE RATE AND FOREIGN EXCHANGE REGIME Figure 1 shows developmens in he curren-accoun-o-gdp raio over he period Turkey has faced currency crises in early 1970, lae 1970 s, 1994 and The figure indicaes ha he probabiliy of a balance of paymens crisis increases in Turkey as he curren-accoundefici-o-gdp raio increases above 5 percen. Sandard economic heory says ha he curren accoun balance improves as he real exchange rae depreciaes, which increases ne expors once he J-curve (he phenomenon whereby he rade balance a firs worsens following a depreciaion has worked iself ou), worsens as domesic absorpion increases (since higher domesic absorpion implies 157

4 Sübidey Togan and Hakan Berumen higher impors), and improves wih increases in foreign absorpion (since higher foreign absorpion implies higher impors abroad, and hus higher expors of he domesic counry). Figure 1: Curren Accoun-o-GDP Raio ( ) CA/GDP Source : Cenral Bank of Turkey In order o sudy he developmens in he real exchange rae (RER) over he period , one has o decide firs on he appropriae mehodology for consrucion of he RER indices. Here one is faced wih four decisions: choice of he price index, choice of he currency baske, choice of weighs and choice of mahemaical formula. 1 In he formulaion of he RER we use consumer price index (CPI) since hese daa are available on a monhly basis for a large number of counries. Regarding he currency baske we consider four cases: in he firs case he baske consiss of US Dollars only, in he second case he baske consiss of 50 percen US Dollars and 50 percen of German Marks, in he hird case we consider he baske consising of German Marks only and finally, in he fourh case we consider he currency baske consising of he currencies of a large number of counries. In his case, we 1 On he mehodology for consrucing RER indices see Chinn (2005). 158

5 The Turkish Curren Accoun, Real Exchange Rae And Susainabiliy consider counries which are major compeiors of Turkey in world markes as well as major suppliers of impored commodiies o Turkey. The counries considered in he fourh case consis of: Wesern Europe: Belgium, France, Germany, Greece, Ialy, Neherlands, Porugal, Spain, Swizerland and he UK Americas: Brazil, Canada, Mexico and he US Middle Eas and Norh Africa: Egyp, Iran, Syria, Tunisia Cenral and Easern European and Commonwealh of Independen Saes Counries: Czech Republic, Hungary, Poland, Russia Asia: China, Indonesia, Japan, Korea, Malaysia, Taiwan, and Thailand. In order o deermine he weighs of differen counries, we used he approach developed by Zanello and Desruelle (1997). According o heir approach, overall rade weighs are derived by combining he bilaeral impor weighs wih he double expor weighs, using he relaive size of Turkish impors and expors in he overall Turkish rade o average boh ses of weighs. One can pu hese in formal erms as m Impor weigh: w ( M / M ) Expor weigh: Overall weigh: i = i k x X i y X w i = ( ) ) X yi + w i = M w X + M i i i + ( i k X + k i X yk X h h h h m i + X w X + M where M i denoes he value of impors of Turkey from counry i, M is he oal value of Turkish impors, X i is he value of Turkish expors o counry i, X is he oal value of Turkish expors, y i is he value of domesic manufacuring producion for home marke of counry i, and X k i is he value of expors of counry k o counry i. The formula used for esimaion of he RER is given by: CPIi RER = CPI / / E i E w i, x i X k 159

6 Sübidey Togan and Hakan Berumen where P sands for he produc sign, i is he index ha runs over he counry s rade parners, CPI i is he CPI of counry i, E i is he exchange rae defined as domesic currency per uni of US Dollar of counry i, CPI is he Turkish CPI, E is he TL/$ exchange rae and w i is he compeiiveness weigh aached o counry i calculaed using he mehod of Zanello and Desruelle (1997). Table 1 shows he rade weighs used in our calculaions. Table 1: Trade Weighs CPI Based WPI Based Belgium-Lux Brazil Canada China Czech Republic Egyp France Germany Greece Hungary Indonesia Iran Ialy Japan Korea Malaysia Mexico Morocco Neherlands Poland Porugal Russia Spain Swizerland Syria Taiwan Thailand Tunisia UK US Toal Source: The auhors 160

7 The Turkish Curren Accoun, Real Exchange Rae And Susainabiliy Nex, following he approach of Sekka and Varoudakis (2000), we define anoher RER measure as he price of radable goods o non-radables. The formula used for he esimaion of his RER is given by WPIi RER = CPI / / E i E w i, where WPI refers o wholesale price index. Table 1 shows again he rade weighs used in he calculaions. Noe ha in boh versions of he RER an increase in RER denoes RER depreciaion. Figure 2 shows he ime pah of four differen esimaes of he RER based on CPI over he period On he oher hand, Figure 3 shows he ime pah of he four esimaes of RER based on he approach of Sekka and Varoudakis (2000). In Figure 3, he firs esimae assumes ha he currency baske consiss of he currencies of a large number of counries wih weighs shown in Table 1. The second esimae considers he currency baske o consis of US Dollars only, he hird esimae assumes ha he share of US Dollar is 50 percen and ha of he German Mark is also 50 percen. In he las case we consider he currency baske o consis of German Marks only. Figure 2: Real Exchange Rae Based on CPI Indexes ( ) Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Zanello $ 0.5 $+0.5 DM DM Source : The auhors 161

8 Sübidey Togan and Hakan Berumen Figure 3: Real Exchange Rae Based on WPI Indexes ( ) Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Zanello $ 0.5 DM+0.5 $ DM Source : The auhors Figures 2 and 3 reveal ha here are five episodes of RER developmens during he period In mid-1970, when Turkey faced a foreign exchange crisis, he RER was devalued by percen. Thereafer he RER sared o appreciae. Afer he foreign exchange crisis of lae 1970 s, he RER depreciaed sharply wih he sabilizaion measures of I kep depreciaing unil 1988 and hen sared o appreciae again. Appreciaion of he RER carried on unil 1994 when he counry was faced wih anoher currency crisis. In 1994 he RER depreciaed sharply bu afer a while RER sared o appreciae again from April 1994 o February 2001 when he counry was faced wih he currency crisis of Afer he sharp depreciaion of he RER during February 2001 o April 2001, he RER sared o appreciae, wih he appreciaion acceleraing afer November To emphasize he exen of annual inflaion and rae of depreciaion of he nominal exchange rae, we show in Figure 4 he ime pah of inflaion and rae of depreciaion of he TL/$ exchange rae, as he growh of CPI compared o is 12 monh period lag value and as he 162

9 The Turkish Curren Accoun, Real Exchange Rae And Susainabiliy growh rae of he TL/$ exchange rae compared o is 12 monh period lag value, respecively, on a monhly basis. The figure reveals ha he annual rae of depreciaion of he TL/$ exchange rae has exceeded he annual rae of domesic inflaion during he crisis periods of 1970, 1980, 1994, 2001 and also during he period February 1980 December 1984 when he governmen was deliberaely pursuing a policy of RER depreciaion. On he oher hand, he rae of inflaion has exceeded he rae of depreciaion of he TL/$ exchange rae during he remaining periods, leading o an appreciaion of he RER. Figure 4: Annual CPI Inflaion and Annual Rae of Devaluaion of he Exchange Rae ( ) Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Annual Inflaion Annual Devaluaion Source : The auhors We nex urn o consideraion of he foreign exchange regime followed by Turkey during he period The IMF in is Annual Repor on Exchange Arrangemens and Exchange Resricions classified he exchange rae policies based on informaion provided by he member counries. During 1970s he IMF indicaed wheher he counry applied par (fixed) values or no. During i furher repored wheher he exchange rae was mainained wihin relaively narrow margins in erms 163

10 Sübidey Togan and Hakan Berumen of he U.S. dollar, Briish serling, French franc, Souh African rand or Spanish pesea, a group of currencies, or a composie of currencies. Finally, during he IMF also emphasized wheher he counry applied special raes for some or all of capial ransacions, impor rae differen from expor rae, more han one rae for impors, and finally wheher more han one rae was applied for expors. Afer 1983 he number of classificaion caegories was expanded o hree. The hreebucke classificaion ha prevailed hrough mos of he 1980 s and 1990 s consised of (i) pegged regimes, (ii) regimes wih limied flexibiliy, and (iii) more flexible arrangemens. The firs broad regime group consiss of wo sub-groups, i.e. single currency pegs and composie currency pegs. The second group has been used o classify he European counries (prior o he moneary union) wih exchange rae arrangemens vis-à-vis one anoher (i.e. he Snake, he Exchange Rae Mechanism, ec.) and he Gulf counries. The hird bucke includes wo sub-groups, i.e. managed floas, eiher according o a se of indicaors or in a counry-specific way, and independen floas. In his classificaion he exchange rae arrangemen (i) refers o fixed, (ii) o inermediae and (iii) o flexible regimes. However, he classificaion had wo major shorcomings. Firs, i failed o capure differences beween wha he counries claimed o be doing and wha hey were acually doing. Second, by lumping rigid forms of pegs ogeher wih sofer pegs i failed o acknowledge he differen degree of moneary auonomy afforded by each regime. To address hese shorcomings, in 1999 he IMF adoped a new classificaion scheme based on sill de faco policies. The new scheme allows for eigh differen caegories ranging from he adopion of a foreign currency as legal ender o free floas. 2 2 The eigh regimes are: (I) dollarizaion and euroizaion, (II) currency board, (III) convenional fixed pegs, (IV) horizonal bands, (V) crawling pegs, (VI) crawling bands, (VII) managed floa wih no preannounced pah for he exchange rae, and (VIII) independen floa. Under convenional fixed pegs he currency is pegged o anoher currency or currency baske wihin a band of a mos +/- 1 percen. While horizonal bands refer o pegs wih bands larger han +/- 1 percen, crawling pegs refer o pegs wih cenral pariy periodically adjused in fixed amouns a a pre-announced rae or in response o changes in seleced quaniaive indicaors. Crawling bands refer o crawling pegs combined wih bands larger han +/- 1 percen. While managed floa wih no preannounced pah for he exchange rae refers o a regime wih acive 164

11 The Turkish Curren Accoun, Real Exchange Rae And Susainabiliy Table 2, in columns 1-4, shows he evoluion of he Turkish exchange rae regime according o he IMF s Exchange Arrangemens and Exchange Resricions. The able reveals ha Turkey applied a par exchange rae regime during , ha he exchange rae was mainained wihin a relaively narrow margin during , and ha he exchange rae was no mainained wihin a narrow margin during According o he IMF, Turkey applied special raes for some or all capial ransacions during 1970 and During Turkey applied impor raes differen from expor raes, and more han one rae for expors, and during i applied, in addiion, more han one rae for impors. During he period Turkey applied special raes for some or all capial ransacions, impor raes differen from expor raes, and more han one rae for impors and expors. Afer 1983 Turkey was classified as having more flexible arrangemens. Laer during i was classified as having a managed floaing, during a crawling peg and during an independenly floaing. inervenions wihou precommimen o a preannounced arge or pah for he exchange rae, he independen floa regime refers o marke-deermined exchange rae wih moneary policy independen of exchange rae policy. This classificaion reas exchange arrangemens II, III, and I as fixed regimes, IV, V, and VI as inermediae regimes, and VII and VIII as flexible regimes. 165

12 Table 2: Exchange Rae Regimes Volailiy of Volailiy of Classificaion Exchange Exchange IMF IMF IMF IMF of Babula Raes Rae Volailiy of Classificaion Classificaion (3) caion (4) Reinhar and Rogoff Classifi- Classificaion of Classificaion (2) and Oker (5) (1) Annual Changes Reserves 1970 (i) + (1) peg o US dollar (i) + (2) + (4) peg o US dollar (i) + (2) + (4) de faco crawling band around US Dollar/parallel marke (i) + (2) + (4) de faco crawling band around US Dollar/parallel marke (i) + (1) de faco crawling band around US Dollar/parallel marke (i) de faco crawling band around US Dollar/parallel marke (ii) + (2) + (3) + (4) de faco crawling band around US Dollar/parallel marke (ii) + (2) + (3) + (4) freely falling/de faco crawling band around US$/parallel marke 1978 (i) + (1) freely falling/de faco crawling band around US$/parallel marke 1979 n.a. freely falling/de faco crawling band around US$/parallel marke 1980 (ii) + (1) + (2) + (3) + (4) freely falling/de faco crawling band around US$/parallel marke 1981 (ii) + (1) + (2) + (3) + (4) managed floaing/parallel marke (ii) + (1) + (2) + (3) + (4) managed floaing/parallel marke (iii) managed floaing (iii) freely falling/managed floaing (iii) freely falling/managed floaing (iii) freely falling/managed floaing (iii) freely falling/managed floaing (iii) freely falling/managed floaing (iii) freely falling/managed floaing (iii) 9 freely falling/managed floaing (iii) 9 freely falling/managed floaing

13 Volailiy of Volailiy of Classificaion Exchange Exchange IMF IMF IMF IMF of Babula Raes Rae Volailiy of Classificaion Classificaion (3) caion (4) Reinhar and Rogoff Classifi- Classificaion of Classificaion (2) and Oker (5) (1) Annual Changes Reserves 1992 (iii) 9 freely falling/managed floaing (iii) 9 freely falling/managed floaing (iii) 7 freely falling/managed floaing (iii) 9 freely falling/managed floaing (iii) 9 freely falling/managed floaing (iii) 9 freely falling/managed floaing (iii) 7 crawling band around DM/freely falling IV 7 crawling band around Euro/freely falling IV 7 crawling band around Euro/freely falling VIII 13 freely falling/freely floaing VIII VIII VIII VIII Noes: 1. The wo regimes are (i) par (fixed), and (ii) no par. (1) indicaes ha special raes are applied for some or all capial ransacions, (2) impor raes are differen from expor raes, (3) more han one rae for impors, and (4) more han one rae for expors. 2. The wo regimes are (i) exchange rae mainained wihin relaively narrow margin, and (ii) exchange rae no mainained wihin relaively narrow margins. (1) indicaes ha special raes are applied for some or all capial ransacions, (2) impor raes are differen from expor raes, (3) more han one rae for impors and (4) more han one rae for expors. 3. The hree regimes are: (i) pegged regimes, (ii) regimes wih limied flexibiliy, and (iii) more flexible arrangemens 4. The eigh regimes are: (I) dollarizaion and euroizaion, (II) currency board, (III) convenional fixed pegs, (IV) horizonal bands, (V) crawling pegs, (VI) crawling bands, (VII) managed floas wih no preannounced pah for he exchange rae, and (VIII) independen floa pah for he exchange rae, and (VIII) independen floa 5. The hireen regimes of Babula and Oker-Robe are: (1) formal dollarizaion and euroizaion, (2) currency union, (3) currency board arrangemens, (4) convenional fixed pegs vis-à-vis single currency, (5) convenional fixed pegs vis-à-vis a baske of currencies, (6) horizonal bands, (7) forward looking crawling pegs, (8) backward looking crawling pegs, (9) forward looking crawling bands, (10) backward looking crawling bands, (11) ighly managed floas, (12) oher managed floas wih no predeermined exchange rae pah, and (13) independenly floaing. Source: Babula and Oker-Robe (2002), Reinhar and Rogoff (2002), and he auhor.

14 Sübidey Togan and Hakan Berumen On he oher hand, while Babula and Oker-Robe (2002) disinguish beween 13 regimes 3, Reinhar and Rogoff (2002) disinguish beween 15 regimes. 4 Table 2 in column 5 repors he exchange regimes followed by Turkey according o he classificaion of Babula and Oker-Robe. The able shows ha Turkey during he 1990s under high capial mobiliy has abandoned he inermediae regimes of forward-looking crawling bands and forward-looking crawling pegs and moved owards a regime of free floas. The Turkish exchange regime, according o he classificaion of Reinhar and Rogoff (2002), is repored in column 6 of Table 2. This classificaion reveals ha Turkey during had muliple exchange raes and also had acive parallel (black) raes. Furhermore, annual inflaion rae in Turkey was running above 40 percen during 1980 and during , which have been classified by Reinhar and Rogoff as freely falling. We supplemen he informaion provided in Table 2 columns 1-4 wih he following addiional measures: (i) volailiy of exchange raes defined as he average of absolue monhly percenage changes in he 3 These regimes are: (1) formal dollarizaion and euroizaion, (2) currency union, (3) currency board arrangemens, (4) convenional fixed pegs vis-à-vis single currency, (5) convenional fixed pegs vis-à-vis a baske of currencies, (6) horizonal bands, (7) forward-looking crawling pegs, (8) backward-looking crawling pegs, (9) forwardlooking crawling bands, (10) backward-looking crawling bands, (11) ighly managed floas, (12) oher managed floas wih no predeermined exchange rae pah, and (13) independenly floaing. The crawl is viewed as backward-looking when he crawl aims o passively accommodae e.g. pas inflaion differenials under a real exchange rae rule, and as forward-looking when he exchange rae is adjused a a preannounced fixed rae and/or se below projeced inflaion differenials, ypically when he exchange rae is envisaged o have an anchor role. Under ighly managed floas inervenions ake he form of very igh monioring ha generally resuls in sable exchange raes wihou having a clear exchange rae pah, so as o permi he auhoriies an exra degree of flexibiliy in deciding he acics o achieve a desired pah. Under oher managed floas wih no predeermined exchange rae pah exchange rae is influenced in a more ad hoc fashion. The classificaion of Babula and Oker-Robe reas exchange arrangemens 1, 2, and 3 as hard peg regimes, 4-11 as inermediae regimes, and 12 and 13 as floaing regimes. 4 The regimes are: (1) no separae legal ender, (2) pre announced peg or currency board arrangemen, (3) pre announced horizonal band ha is narrower han or equal o +/- 2 percen, (4) de faco peg, (e) preannounced crawling peg, (5) preannounced crawling band ha is narrower han or equal o +/- 2 percen, (6) de faco crawling peg, (7) de faco crawling band ha is narrower han or equal o +/- 2 percen, (8) preannounced crawling band ha is wider han or equal o +/- 2 percen, (9) de faco crawling band ha is narrower han or equal o +/- 5 percen, (10) moving band ha is narrower han or equal o +/- 2 percen, (11) managed floaing, (12) freely floaing, (13) freely falling, and (14) hyperfloas. 168

15 The Turkish Curren Accoun, Real Exchange Rae And Susainabiliy nominal exchange rae during a year, (ii) volailiy of exchange rae changes defined as he sandard deviaion of he monhly percenage changes in he nominal exchange rae during a year, and (iii) volailiy of reserves defined as he average of absolue monhly changes in he non-gold reserves, normalized by he reserve money in he previous monh. We noe ha fixed regimes have low values for volailiy of exchange raes, low values for volailiy of exchange rae changes and high values for volailiy of reserves. On he oher hand, flexible regimes combine high values for volailiy of exchange raes and volailiy of exchange rae changes wih low values for volailiy of reserves. The esimaed values of volailiy of exchange raes, volailiy of exchange rae changes and volailiy of reserves for Turkey repored in columns 7-9 in Table 2 for reveal ha he volailiy of exchange raes, volailiy of exchange rae changes, and volailiy of reserves have been low during he 1970s. Furhermore, volailiy of exchange raes and volailiy of exchange rae changes during and during 2000 have been relaively low, and during he period when Turkey ried o achieve annual RER devaluaion of abou 6 percen, he volailiy of reserves has been raher low. On he oher hand, during 2000 when Turkey followed a semi currency board arrangemen he volailiy of reserves has been relaively high. The volailiy of reserves sared o increase afer he liberalizaion of inernaional capial movemens in As he exchange rae became more and more deermined by he marke, he volailiy of exchange raes and volailiy of reserves increased considerably during he periods and also during During he crises periods of 1994 and 2001, he values for all hree measures increased enormously. During he period he counry has experienced relaively high values of volailiy of reserves, bu relaively low values of volailiy of exchange raes. 169

16 Sübidey Togan and Hakan Berumen III. PRICE EFFECTS IN TURKISH FOREIGN TRADE From economic heory we know ha he curren accoun balance improves wih depreciaion of he RER, worsens wih increases in domesic absorpion, and improves wih increases in foreign absorpion. To deermine hese relaions empirically, we consider he imperfec subsiues model of inernaional rade, he key underlying assumpion of which is ha neiher impors nor expors are perfec subsiues for domesic goods. Impor (expor) demand and supply are modeled as funcions of he relaive price of impors (expors) and of aggregae demand for goods and services. The Model The quaniy of impored goods demanded is assumed o depend on real domesic aggregae demand and he real exchange rae: M d = M d (π, AD) where M d is he quaniy of foreign goods impored, AD is he level of real domesic aggregae demand measured a consan prices, and π = RER (1 + ). Here is he ad valorem average ariff rae on impors. The demand for expors (foreign impors) depends on real foreign aggregae demand AD* and foreign relaive price of impors π* by he res of he world: M d* = M d* (π*, AD*) where M d* is he quaniy of expors, π* = (p x / E p f ) is he relaive price of impors abroad. Here p x is he price of exporables by he home counry measured in erms of domesic currency, and p f is he foreign price of commodiies produced by he res of he world measured in erms of foreign currency. We assume ha he supply schedules of imporables are perfecly elasic. On he oher hand, he supply of exporables in he home counry is 170

17 The Turkish Curren Accoun, Real Exchange Rae And Susainabiliy assumed o depend on he price of exporables p x, relaive o he home price p of goods produced by he home counry, measured in erms of domesic currency and and real income y in he counry: X s = X s (p x /p, y) where X s is he supply of home counry exporables and y denoes he real GDP. Here, expors are assumed o rise as real income serving he purpose of an index of producive capaciy of he counry rises. Imposing he equilibrium condiion in he marke for exporables M d* = X s, and expressing all relaions in naural logarihms we ge (1) ln M = α 0 α 1 ln [RER (1 + )] + α 2 ln AD (2) ln M d* = β 0 - β 1 ln (p x /E p f ) + β 2 ln AD* (3) ln X s = γ 0 + γ 1 ln (p x /p) + γ 2 ln y (4) ln M d* = ln X s Solving equaions (2) (4) for expors we obain (5) ln X = a 0 + a 1 ln RER + a 2 ln AD* + a 3 ln y where RER = (E p f /p), a 1 > 0, a 2 > 0 and he sign of a 3 is indeerminae. 5 Daa Sources We now consider he annual daa for he period Daa on Turkish GDP a consan prices, on expors and impors of goods a curren prices measured in US dollars, and on aggregae domesic demand defined as he sum of consumpion, plus invesmen plus governmen expendiures a consan prices, have been obained from 5 The lieraure on rade equaions is vas. Goldsein and Khan (1985) provide excellen discussion. 171

18 Sübidey Togan and Hakan Berumen he Sae Planning Organizaion. Tariff revenue figures excluding he VAT paymens on impored commodiies a curren prices were obained from he websie of he Minisry of Finance. Annual daa on foreign aggregae demand, defined as he weighed sum of consumpion plus invesmen plus governmen expendiures a consan prices of various OECD counries, have again been obained from he OECD. 6 Expor and impor price indexes of goods on a monhly basis were obained from Cenral Bank publicaions and Sae Insiue of Saisics. Finally, he RER daa were obained on a monhly basis following he mehod described above. The impor and expor values have been convered o real impors and expors using he expor and impor price indexes. In he esimaion of impor and expor funcions, we use real expors and real impors measured in erms of millions of 1987 US dollars. When esimaing he impor funcion we use RER daa adjused for he ariff raes as shown in equaion (1). Empirical Evidence In order o observe he equilibrium relaionship, we esimae he longerm sable relaionship for expors and impors using heir basic deerminans. We adoped Johansen s coinegraion esimaion mehod o idenify he long-erm relaionship for hese variables. Before going ino he deails of esimaion, we performed heeroscedasic robus and Phillips and Perron (PP) uni roo ess for he variables of ineres. The es resuls are abulaed in Table 3. Tes saisics canno rejec he presence of uni roos in levels for all he series considered when we included boh consan, and consan and ime rends. However, we can rejec he null of he uni roo wih he inercep for he firs differences of all he series. Therefore, we can safely assume ha all he series considered are differen saionary or I (1). 6 The weigh of Belgium is 4.47 percen, Canada 0.81 percen, France percen, Germany percen, Ialy percen, Japan 4.94 percen, Neherlands 4.72 percen, Spain 3.8 percen, Swizerland 4.1 percen, Unied Kingdom 11 percen, and USA percen. 172

19 The Turkish Curren Accoun, Real Exchange Rae And Susainabiliy Table 3: Uni Roo Tes Resuls Consan Consan and Trend Firs Difference PP PP PP Real impors of consumpion goods ** Real impors of invesmen goods ** Real impors of non-energy inermediae goods ** RER inclusive of ariffs ** Real domesic demand ** Real expors ** RER ** Real foreign demand ** Noe: ** indicaes he level of significance a he 1 percen level and * indicaes he level of significance a he 5 percen level. The esimaed impor demand schedules are presened in Table 4. During he esimaion we firs separae oal impors ino energy and non-energy impors. Nex, we spli non-energy impors ino impors of consumpion goods, impors of invesmen goods, and impors of nonenergy inermediae goods. We noe ha for pracical purposes, energy impors depend on he price of oil raher han he RER. Spliing nonenergy impors ino consumpion, invesmen and non-energy inermediae goods is relevan since he RER elasiciy of consumpion goods, invesmen goods, and non-energy inermediae goods are quie differen, and since here may be an increase in impors of inermediae goods over ime reflecing a srucural shif in he expor paern owards assembly-driven operaions as a resul of closer inegraion ino inernaional producion neworks. The resuls show ha he RER elasiciy of impors of consumpion goods, invesmen goods and nonenergy inermediae goods, in case a CPI-based measure of he RER obained using he mehod of Zanello and Desruelle (1997) is used, are 173

20 Sübidey Togan and Hakan Berumen , and respecively. 7 Similarly domesic demand elasiciy of impors of consumpion goods, invesmen goods, and nonenergy inermediae goods are , and respecively. The figures reveal high suscepibiliy of impor flows o aggregae domesic demand. Table 4: Impor Funcions Logarihm of Logarihm of CPI based real Dependen RER inclusive domesic variable Consan of ariffs demand Real impors of consumpion goods ( ) ( ) ( ) Real impors of invesmen goods ( ) ( ) ( ) Real impors of non-energy impors of inermediae goods ( ) ( ) ( ) Noe: -saisics are displayed in parenhesis. The esimaed expor supply schedule is given in Table 5. The elasiciy of expors wih respec o foreign aggregae demand is esimaed as On he oher hand, price elasiciy of expors, when he CPI-based measure of he RER obained using he mehod of Zanello and Desruelle (1997), is measured as When deflaing he expor and impor values measured in erms of curren US Dollars by he expor and impor price indexes we have used for he period , he price indexes published on a monhly basis by he Cenral Bank of Turkey, and for he period , he price indexes published by he Sae Insiue of Saisics. The impor values of invesmen goods have been deflaed by he impor price index of invesmen goods published by he Cenral Bank of Turkey over he period All oher impor and expor values have been deflaed by he general price indexes respecively as obained above. 174

21 The Turkish Curren Accoun, Real Exchange Rae And Susainabiliy Table 5: Expor Funcion Logarihm of Logarihm of CPI based real Dependen RER inclusive foreign variable Consan of ariffs demand Logarihm of real expors ( ) (0.437) (5.4118) Noe : -saisics are displayed in parenhesis. We noe ha he Marshall-Lerner condiion holds as he absolue values of esimaed price elasiciies for impors deermined by he relaionship mcon minv m η im = ηcon ( ) + ηinv ( ) + ηne ( m m m ne ) and expors sum up o more han uniy, where η con denoes he price elasiciy of impors of consumpion goods, η inv price elasiciy of impors of invesmen goods, η ne price elasiciy of impors of non-energy inermediae goods, m con impors of consumpion goods, m inv impors of invesmen goods, m ne impors of non-energy inermediae goods, and m oal impors. We noe ha impor price elasiciy is η im = and ha expor price elasiciy is η ex = The Marshall-Lerner condiion indicaes ha he rade balance improves following a real depreciaion of he domesic currency. IV. A FRAMEWORK FOR ASSESSING THE SUSTAINABILITY OF THE CURRENT ACCOUNT Swan (1963), in a pah-breaking paper aking produciviy, he erms of rade, capial movemens and oher financial variables as given and assuming no special impor resricions imposed on balance of paymens grounds, shows how employmen and he balance of paymens boh depend on he level of spending and on he relaive cos siuaion. In Figure 5 real expendiure is he oal domesic invesmen and consumpion 175

22 Sübidey Togan and Hakan Berumen (privae and public) a consan prices, called AD for shor; and he cos raio is an index measuring compeiive posiion of indusries. Figure 5: Swan Diagram Source : Swan (1963) Considering ha for he cos raio RER, we noe ha a given level of employmen can be susained wih AD very low if RER is high enough, and vice versa. This is shown by Schedule A, where A 2 refers o full employmen, A 1 underemploymen and A 3 over-employmen. Similarly a given balance of paymens requires a combinaion of low RER and low AD, or high RER and high AD. This is shown by Schedule B, where B 2 sands for susainable level of balance of paymens defici, B 1 for a relaively smaller defici and B 3 for a relaively larger defici. Swan (1963) poins ou ha here are many A and B curves for differen levels of employmen and balance of paymens. Any combinaion of RER and AD along A 2 gives he inernal balance, and any combinaion of B 2 gives exernal balance. The inersecion of hese wo curves gives us he equilibrium values of RER and AD ha will aain inernal as well as exernal balance. The equilibrium value of he RER, 176

23 The Turkish Curren Accoun, Real Exchange Rae And Susainabiliy called he fundamenal equilibrium exchange rae (FEER), is hus a normaive one, and i is characerized by Williamson (1994) as he equilibrium exchange rae ha would be consisen wih ideal economic condiions. Alhough he deerminaion of he inernal balance relaion A 2 is raher sraighforward, he deerminaion of exernal balance B 2 depends on he way ha he susainable level of curren accoun is defined. To aack he problem of deerminaion of susainable level of curren accoun, we consider he simple accouning mehodology developed by Milesi- Ferrei and Razin (1996), which makes use of he balance of paymens $ relaion wrien as TB i D + FDI + D D = 0 where TB $ denoes * 1 1 he non-ineres curren accoun, i* he foreign rae of ineres, D he sock of foreign deb, and FDI he foreign direc invesmen inflow. Noe ha $ ( i * D 1 TB ) = Curren Accoun and ( FDI + D D 1 ) = Capial Accoun, where all variables are measured in erms of foreign currency. Wriing he non-ineres curren accoun explicily by spliing oal impors ino energy and non-energy impors and considering he EU grans we have: TB $ = Expors Energy Impors Non-Energy Impors + EU Grans + Oher where all variables are measured in erms of foreign currency, and Oher sands for Curren Accoun - Expors + Energy Impors + Non- Energy Impors + i* D -1 - EU Grans. 8 Nex we define he non-energy and non-ineres curren accoun E D surplus, NETB = (Expors Non-Energy Impors + Oher). If d = p y 8 Here we assume ha EU grans are in he form of curren ransfers. If EU grans would be in he form of capial ransfers, hey would be shown no in he curren accoun bu in he capial accoun of he balance of paymens. Since his is purely a maer of definiion, for our purposes i is no of imporance wheher EU grans are shown under curren accoun or capial accoun of he balance of paymens. 177

24 Sübidey Togan and Hakan Berumen is he foreign deb o GDP raio; ne b E NETB $ = he non-ineres non p y energy curren accoun surplus in proporion o GDP; energy = (E x Energy Impors / py) he energy impor bill o GDP raio; eugrans = (E x FDI E EU Grans / py) he EU grans o GDP raio; and fdi = he FDI o p y GDP raio, he equaion deermining he ime pah of d which also sands for he economy s ineremporal financing consrain can be wrien as: ( 1 )(1 η ) (1 ) * + r + (6) d = neb + d 1 + energy eugrans fdi + g, * where r denoes he foreign real rae of ineres and η he rae of depreciaion of he RER. The equaion reveals ha he exernal deb o GDP raio decreases wih increases in he non-ineres, non-energy curren accoun surplus in proporion o GDP neb, EU grans o GDP raio eugrans, he FDI o GDP raio fdi, and he growh rae of GDP g. By conras, he deb o GDP raio increases wih increases in he foreign real ineres rae r*, rae of depreciaion of he RER η, and energy impor bill o GDP raio energy. Following he approach of von Hagen and Harden (1994), we solve he economy s ineremporal financing consrain forward for n periods and obain: n k 1+ g i (7) d = Γδ, n d + n + Γ δ, i A + i where δ, k = and * (1 + r )(1 η ) A i= 1 i= 1 i + = neb + fdi + eugrans energy. Here,, k δ can be inerpreed as he k-periods ahead discoun facor used o calculae he presen value of asses and liabiliies in period + k for period, and Γ denoes he x + k period expecaion of he variable x in period + k. The economy s ineremporal financing consrain indicaes ha, when ineremporal solvency holds (so ha d +n is finie), curren deb-o-gdp raio equals he i 178

25 The Turkish Curren Accoun, Real Exchange Rae And Susainabiliy expeced discouned presen value of foreign deb ousanding in period +n relaive o GDP, plus he sum of all discouned A s beween period and period + n. To ranslae he ineremporal budge consrain ino a pracically more relevan requiremen for deb susainabiliy, we consider he budge consrain for a limied period of ime n* and add he susainabiliy condiion ha he discouned deb/gdp raio a he end of period +n*, discouned d +n* should no exceed he deb/gdp raio a ime, d. Thus, curren accoun is no susainable if: (8) S( n*) d Γδ, d < 0. 9 = n +n bu his susainabiliy condiion, while useful, is no easy o assess in pracice. Even under iniial negaive A values over he nex few years, he curren accoun can be said o be susainable if during he laer periods large posiive non-ineres non-energy curren accoun o GDP, EU grans o GDP, FDI o GDP and relaively low values of energy impor bill-o-gdp raios are assumed. The analysis hus depends on he assumpions one makes abou he evoluion of A +n over ime. V. SCENARIOS FOR THE SUSTAINABILITY OF THE CURRENT ACCOUNT In he exercise conduced below we inroduce he following assumpions: We assume ha n* = 10, and assume in he base case he coninuaion of he presen policies ino he fuure. In paricular we assume ha he value of neb 2005+i for i = 1,..., 10 will remain unchanged a is iniial value of neb 2005 = percen. 9 The formulaion of he susainabiliy problem hrough he difference equaion (6) assumes ha FDI is a surer and safer form of exernal financing. Thus he analysis is he paper assumes ha curren accoun deficis financed mainly by FDI inflows does no lead o problems of susainabiliy of curren accoun, bu if FDI akes he form of purchases of socks and if hese shares can be liquidaed easily in domesic markes, hen i is possible o ake he money ou of he counry as in oher forms of invesmen. In hose cases FDI makes no difference and here is no reason o separae FDI flows in he difference equaion (6). Under hese condiions, susainabiliy of he curren accoun will require higher raes of depreciaion of he RER han hose obained in our analysis given in secion

26 Sübidey Togan and Hakan Berumen In he case of energy producs, we noe ha he average price of oil ($/barrel) has increased from $54.45 in 2005 o $64.34 in 2006, and ha he price of Russian naural gas (US$/1000 m 3 ) from $ in 2005 o $ in Concenraing in he following on oil impors only we assume under he base case ha he price of oil (US$/barrel) will decrease o $58.4 in 2007 and o $50 hereafer. Thus, given energy 2005 = 5.39 percen we have energy 2006 = 6.37 percen, energy 2007 = 5.79 and energy 2005+i = 4.95 for i = 3,..,10. Regarding EU grans, we assume in he base case ha EU grans amoun o 300 million Euros in 2005, 500 million Euros in 2006, 550 million Euros during , 700 million during and 2 billion Euros during Regarding he growh rae of real income, we noe ha he average value of he growh rae of real GDP amouned o 4.08 per cen during and o 4.3 percen during The 2005 Pre- Accession Economic Programme published by he Sae Planning Organizaion a he end of 2005 foresees a growh rae of 5 percen over he nex few years. The growh rae of real GDP in 2006 is expeced o be around 6 percen. For he growh rae of GDP over he ime period 2007 o 2015 we ake he figure of 5 per cen in he base case, i.e. g 2005+i = 0.05 for i = 2,.., 10. To deermine he foreign ineres rae, we use he yields on Eurobonds issued by he Turkish Treasury. The average rae of reurn on Turkish US dollar-denominaed Eurobonds during he las few years amouned o percen in 2002, percen in 2003, percen in 2004, 7.93 percen in 2005, and 7.13 percen during he firs few monhs of Considering he value of 7.93 and deflaing i by expeced US CPI inflaion rae over he nex few years, we obain a figure of 5.91 percen for foreign real ineres rae. In he following we 10 When convering he Euro values ino US Dollar values we use he exchange rae where 1 Euro equals US$ We would like o hank Tekin Couk of he Undersecrearia of he Treasury for providing he daa on Turkish Eurobonds. 180

27 The Turkish Curren Accoun, Real Exchange Rae And Susainabiliy ake he figure of 6 percen for real foreign ineres rae in he base case, i.e. r* 2005+i = 0.06 for i = 1,.., 10. Nex we consider he rae of depreciaion of he RER. Alhough he CPIbased RER has appreciaed over he period a he annual rae of 7.53 percen, and he WPI-based RER a 7.66 percen, we absrac from furher appreciaion or depreciaion of he RER under he base case due o he Balassa-Samuelson effec under he base case and assume ha η 2005+i = 0 for i = 1,..., Concerning he FDI/GDP raio, we noe ha while, during he period he average FDI/GDP raio amouned o 0.76 percen, he raio increased o 2.7 percen in 2005 as a resul of privaizaions and privae secor mergers and acquisiions. On he oher hand, he 2005 Pre-Accession Economic Programme foresees FDI/GDP raio of percen over he nex few years. Preliminary bes guess esimaes of FDI inflows for 2006 amoun o $19 billion, and he forecass are $14.2 billion for 2007, $8.5 billion in 2008, $8.2 billion in 2009 and $8 billion hereafer. Nex we consider a high-case scenario. Here we assume he price of energy producs o rever o a lower level (emporary shock) saring from he fourh quarer of Concenraing on he price of oil, we assume ha he average price of oil (US$/barrel) will decrease from $62.33 in 2006 o $44.00 in 2007 and furher o $41.50 hereafer. Furhermore we assume ha he growh rae of real GDP will amoun o 7 percen, and he foreign real ineres rae will be 4 percen during he period The assumpions inroduced in he base and opimisic cases are summarized in Table For a discussion of Balassa-Samuelson effec see Togan and Berumen (2006). Noe ha he curren accoun is assumed o be independen of RER appreciaion, driven by produciviy growh. 13 In he fourh quarer of 2006 he average price of oil (US$/barrel) is assumed o be $56.42 under he base case and $48.50 under he opimisic scenario. 181

28 Table 6: Assumpions of he Base and Opimisic Cases Non-Ineres Annual FDI Balassa- Samuelson Oil Price Growh Rae of GDP Foreign Real Ineres Rae Non-Energy Curren Accoun A EU grans Inflow Effec Base Opimisic Base Opimisic Base Opimisic -o-gdp Raio Base Opimisic Time Euros US$ billion (percen) $/barrel $/barrel (percen) (percen) (percen) (percen) (percen) (percen) (percen) million level million level million level million level million level million level million level million level billion level billion level