Currency fair value
Rob n Brooks, econom st, IIF
The Argentinian peso and Turkish lira both fell sharply last year, but the underlying stories are fundamentally different. Argentina is closer to the classic EM template, where an unsustainable policy mix caused the real exchange rate to appreciate significantly and the current account deficit to widen. Last year’s devaluation was an unwind of that imbalance. In contrast, the Turkish lira has trend depreciated for many years and is the weakest currency across the EM complex. The driver of Turkey’s crisis, instead, was an outsized credit boom, which widened the current account deficit to unsustainable levels. The question we address here is whether both currencies are now cheap, given they have fallen so much and current accounts are adjusting. Our valuation framework says no. The underlying intuition for this is that our framework discounts cyclical forces, which are driving much of the current account swings at this stage. We have estimated that the large devaluations Turkey and Argentina saw last year come with peak-to-trough contractions in activity of 10 per cent, which means that import compression is the main driver of adjustment. This looks to be the case in Turkey and Argentina. Our valuation framework allows us to disentangle the various forces driving current account adjustment. We control for: (i) lagged devaluation effects still in the pipeline; (ii) widening output gaps, where – given considerable uncertainty – we assume a range from -1 to -6 percent for Turkey and Argentina in 2019; and (iii) trade-weighted foreign output gaps based on data from the IIF database. Feeding through lagged devaluation effects and closing domestic and foreign output gaps allows us to compute an underlying current account balance, which is close to -1 per cent of GDP in Turkey as well as Argentina. This is close to our savinginvestment norm for both places – i.e. the fundamentals-consistent current account level – meaning that both currencies are essentially at fair value here, not undervalued.