What is to be done?
“The truth is always a compound of two half-truths, and you never reach it, because there is always
something more to say.”
The current account deficit is identically equal to the savings gap at a given growth rate. Financing the current account deficit by means of asset investments, i.e. the financial account, amounts to financing domestic growth by using foreign savings. Hence, if the current account deficit has to be reduced by some means, growth should slow down. Maintaining the growth rate intact requires an increase of domestic savings, either private or - more realistically in the present case - public. This means fiscal deficits should be adjusted, that is “reduced”, as the current account deficit narrows. Obvious though it may be, this point is often overlooked. The interesting thing is to develop an idea of how the rate of interest – the real rate and the exchange rate, the real exchange rate - should behave during the dynamics of change. Hence, there is an impasse: public spending – direct or as quasi-fiscal - pulls growth up but public savings should increase in order to finance growth while the current account deficit narrows. There may be two impacts in opposite directions. Ordinarily, spending is chosen because it means a direct injection that can be effective quickly. If you choose that path, then be ready for currency shocks, especially if monetary policy is behind the curve.
Similarly, if you try to curtail TRY liquidity either because you don’t want TRY liquidity to create demand for dollars or because you want to discourage short sales and you reduce swap volumes somehow, then TRY interest rates go up in sort of an inordinate way. There is a price for everything. This is what has been happening over the last week. Nevertheless, the malaise is genuine and firmly entrenched in the structure of the economy.
What s the d sease? Corden Syndrome, run backward?
There is a roundabout way of putting things in perspective. Turkey has been awash with dollar liquidity as if it were a specie inflow two times in the 2000s. In a world awash with dollars, that was almost typical, i.e. many EMs benefited from those waves. The first was the episode between 2002 and 2008 – the ‘global savings glut’; the other was the post-Lehman rush to EM assets. As a result, people developed a habit. Anyhow, global liquidity or any local capital inflow would come to the rescue and finance both the debt service and the current account deficit. Again, after such exuberant boom periods there is a price to be paid.
The classical mechanism works like this: As a result of precious specie inflows, consumption of both tradables and non-tradables increase. Since non-tradables ought to be produced locally, labor flows from the tradables sector to the non-tradables sector. Physical marginal productivity of labor falls in the non-tradables sector and rises in the traded sector. Since, in equilibrium, the value of the marginal product of labor needs to be equal across sectors, the price of non-traded goods in terms of traded goods must increase, i.e. real exchange rate appreciation. Consumption demand for tradables will expand more than demand for non-tradables, and the trade balance will deteriorate. The resulting trade deficit, translated into the current account deficit, is financed through the part of specie inflow not claimed by the government. The graph above summarizes the likely course of key variables. Exports may increase, but it is not because labor allocated to the production of tradables increase. It is because labor productivity rises. As long as specie inflow continues, and therefore expectations are predicated upon this assumption, both consumption and utility (welfare) increase overall. However, this is not the end of the story. The Dutch disease phenomenon is generally associated with specific factors, the presence of learning-by-doing, rent-seeking behavior, human capital d-eaccumulation and suchlike. The Dutch disease is a disease only insofar as it discourages human capital accumulation, encourages rent-seeking, and leads to a loss of know-how and ability to produce in the tradable sector as a result of the discontinuity in the path-dependent learning-by-doing path, as Ken Arrow meant it back in 1962.
The most robust symptom of Dutch disease is an overvalued exchange rate. Furthermore, the variance of the real exchange rate had considerably increased in the Spanish case, both factors leading jointly to the destruction of previously highly regarded export bases of Spain’s mainland. A perma-
nent overvaluation and high volatility of the exchange rate had led to over-borrowing by the government. In the end, the exchange rate abruptly adjusts to the cessation of specie inflow, and the country may remain addicted to the previous pattern, having already lost competitiveness in international markets, and also lost long-term sources of growth as mentioned above. Please note that the Dutch disease mechanics can only operate if the specie inflow is perceived as an increase in permanent income. In the end, Dutch disease specifically entails a squeeze of tradable production that is likely to become a long-term feature of the economy. Obviously, this isn’t the case here. But except the ‘overvaluation’ phenomenon, many things are almost identical. The reason why the economic cycle didn’t nosedive right after 2008, i.e. the end of lira overvaluation and the end of the world awash with dollar liquidity Mark 1, is the unprecedented balance sheet effects driven both by the Fed and the ECB that caused dollar and euro liquidity Mark 2. Had it not been for the 4.5 times expansion of the Fed’s balance sheet, zero interest rates – even negative in real terms, etc. - a typical boom-bust cycle would have occurred a decade ago.
Speculat ve attack versus system c r sk
Max Corden notes that in the presence of international capital mobility, the exchange rate may appreciate more for a given rate of monetary contraction. Secondly, the exchange rate will respond more rapidly in this case both for expectational reasons and because capital movements are speedier than real expenditures. There may be overshooting as a result of these factors in the sense that the exchange rate could appreciate more than warranted and faster than expected. In other words, Dutch disease might cause a bigger than expected current account deficit in the presence of international capital mobility. Furthermore, even temporary capital inflows can create additional demand for government securities and help reduce the real rate of interest. Falling interest rates can cause investment demand to increase. What he calls “exchange rate protection” may occur through direct intervention, sterilized through open market operations or by means of budget surplus, or both. This is the way to protect the tradables sector. There remains of course the possibility that even if such intervention takes place the exchange rate can still appreciate. With an inefficiently high FX reserve carried by the Central Bank, the currency could remain overvalued if inflows were to reach abnormally high magnitudes.
D s nflat on, Mark 2
Disinflation means a lot for Turkey. The Turkish economy had developed long inflation memory that persisted until the recent past. Disinflation is therefore still key. However, from 18 percent - a likely CPI year-end forecast - to single-digit inflation anew there is a long way to go. From 8 percent trend inflation to 5 percent trend inflation there was a long way too, and it couldn’t be achieved. And stabilizing inflation somewhere below 10 percent is not an easy task now. Even if monetary and fiscal policies function well in tandem, the process can still be reversible, given adverse exogenous factors, and inflation may pick up until it reaches the quicksand of double digits. The current account deficit deserves a symptomal reading and it is the price we pay for quick disinflation. The deficit, structural though it has always been, has been financed in real continuous time when the political authority began to lose control over the entire political process. Half-full was the glass once again, but now it is perceived as half-empty. The sea change has fundamental reasons, but it is nonetheless true that fundamentals that did not play any role thus far have all of a sudden begun to look like unsurmountable problems. “Why now?” deserves an answer that points to domestic factors, and to the bearers of a long recognized, time-honoured tradition of the now infamous cognitive deficiency syndrome. This syndrome can quickly become a contagious phenomenon in this country.
Accommodate, then d rectly attack the overseas r sk component
The current market prices aren’t equilibrium prices. The rate of interest is far too high. The exchange rate is far too undervalued. Still, even if the exchange rate stabilizes around USD/TRY = 5, that is just at the node where it jumped so steeply by the end of July, it means around 30 percent depreciation compared to January 1. It adds to inflation by about 450 basis points. So far as the “bubble” or speculative attack argument goes, that’s about it. There are obvious things to do such as adopting a fiscal rule that aims at cutting the budget deficit from, say, two percent of GDP all the way down to much less than one percent, raising the primary surplus target, accommodating the trend component of market interest rate rises, say by 300 basis points, etc. Already, irrespective of whatever is to be done, a GDP growth slowdown to 3-4 percent is on its way. Accepting this fact will be the beginning of all beginnings. Then, a convincingly well-elaborated long-run program that would render an IMF stand-by redundant because it will encapsulate the basic ingredients of all reasonable stabilization packages plus a long-run adjustment and restructuring drive. Sine qua non for the long-run, that is. All sectoral rebalancing acts should follow from there, obviously incorporating financial restructuring demands also. The key is credibility. A pretend-but-perform mechanism is warranted.