Exchange Market Pressure in Turkey
Faculty of Economics and Business
MSc Economics, International Economics & Globalization
Yayi Ren (10484906) yayi.ren@student.uva.nl Prof. Franc Klaassen (Supervisor) Dr. K. Mavromatis (second reviewer)
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Contents
1. Introduction ... 2
2. Economic characteristics and policies of Turkey ... 6
3. Literature review ... 11
3.1 EMP components ... 11
3.2 EMP weights... 13
3.3 Turkey- specific review ... 14
4. Empirical study ... 16
4.1 Methodology ... 16
4.2 Data description ... 19
5. Empirical results and ananlysis ... 26
5.1 Calculating each component ... 26
5.2 EMP in turkey ... 31
6. Conclusion ... 36
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1. Introduction
To see on the surface, Turkey is a fast-developing country with 8717 US dollars GDP per capita in 2013 (see figure 1). It had moderate growth after the 2008 economic crisis. However, many people have the vague and unclear feeling of potential crisis because of recent economic turbulence in Turkey and start to worry about this country (e.g. Kaya, 2013). Recent turmoil of emerging markets has produced the term “Fragile Five” which is first introduced by Morgan Stanley in August 2013 and meant to describe the economies of Turkey, Brazil, South Africa, India and Indonesia. Council on Foreign Relations1 points out that the five countries were dubbed the "Fragile Five" due to the increasing pressure on their currencies, raising a potential crisis in emerging markets. By exploring the exchange market, early signs of crisis can be observed in a way. This paper tries to focus on one of the five countries – Turkey as a representative to give an exposition of its exchange market conditions.
GDP per capita (constant 2005 USD) GDP per capita growth (annual %) Figure 1 GDP per capita and GDP per capita growth in Turkey
High inflation, large current-account deficit, depreciation and political risks in Turkey reduce the confidence of not only domestic investors but also foreign investors because Turkey is considered heavily dependent on foreign capital to finance their
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The Council on Foreign Relations (CFR) is an independent, nonpartisan membership organization and publisher (www.cfr.ofg).
-8 -6 -4 -2 0 2 4 6 8 10 4000 4500 5000 5500 6000 6500 7000 7500 8000 8500 9000 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
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economic boom (see section 2). This adds to the vulnerability of the economies, especially in the foreign exchange market2. Additionally, the US Federal Reserve has been increasing liquidity in financial markets since the end of 2008. The capital inflows and low interest rates enable the emerging markets to keep high growth rates and finance their deficits. But the reducing quantitative easing from middle 2013 of the US Federal Reserve caused currency weakness against US dollar in these countries relying on cheap funding3. All these situations make the exchange rate of the Turkish Lira vis-à-vis the US Dollar volatile. Due to the dependence on fugacious external financing and the fact of capital flight, Turkey might be under great pressure of depreciation.
Figure 2 shows evident depreciation of the Turkish Lira in recent years. The Central Bank of the Republic of Turkey (CBRT) has taken action to improve their economic stabilities. For instance, on January 28th 2014, Turkey's central bank decided to implement tight monetary policy and raised rate sharply: its overnight lending rate from 7.75% to 12%, one-week repo rate from 4.5% to 10% and overnight borrowing rate from 3.5% to 8%. One of the objectives of raising the rate is to stem the depreciation of the Turkish Lira4. As a result, the currency was strengthened from 2.253 to 2.2 per dollar after the action and brought gains immediately. As a matter of fact, the exchange rate fluctuation only shows part of the pressure in Turkish foreign exchange market. In this case, we intend to reveal the real pressure behind the appearance.
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See the article “Turkey’s economy is vulnerable” (Hugo Dixon, 17/06/2013) on Reuters website.
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See the article “Currency crises in emerging markets” (Mohammed Aly Sergie, 24/01/2014) on the Council on Foreign Relations website.
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See the articles “Turkey raises rates to halt lira’s slide” (Daniel Dombey, 29/01/2014) on Financial Times website and “Turkey raises rates sharply to bolster currency” (Yeliz Candemir and Joe Parkinson, 28/01/2004) on the Wall Street Journal website. One can also analyze the decision of the monetary policy committee released on 28 January 2014 of the CBRT.
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Figure 2 Monthly average exchange rate (Turkish Lira per US Dollar)
A good indicator of the tension on the foreign exchange market is exchange market pressure (EMP), which is a concept first suggested by Girton and Roper (1977) to measure the volume of intervention necessary to achieve the desired exchange rate target. Then Weymark (1997) expressed the exchange market pressure by the exchange rate change that is required to remove excess supply for a currency on the foreign exchange market without policy intervention. This is a widely adopted definition in researches and will be used in this thesis.
The aim of this thesis is to quantify the exchange market pressure in Turkey and to demonstrate the foreign exchange market situation and trends in Turkey, through which the characteristics of its exchange market will be shown. The key part of the thesis is to have a good EMP measure since it is relevant for at least two reasons (Klaassen and Jager, 2011). Monetary policy makers influence the exchange rate more or less under exchange rate management and free floating regime. It is important for them to know the magnitude and severity of exchange market pressure and the effectiveness of their instruments in offsetting it. Moreover, the EMP concept can be used to examine other phenomena. Once the EMP of Turkey is clarified, more studies could be facilitated with this tool index. In most literature, the exchange market pressure of emerging market is measured depending on structural economic models in which they do not compare current policy variables to the counterfactual values
0 0.2 0.4 0.6 0.81 1.2 1.4 1.6 1.82 2.2 2.4
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according to the definition but to the lagged ones. This paper uses a definition-consistent and model-free approach introduced by Klaassen and Jager (2011) to measure the exchange market pressure in Turkey.
The rest of the paper is organized as follows. Section 2 introduces the economic conditions and recent turmoil of Turkey, including the characteristics of the foreign exchange market in the analysis of monetary and exchange rate policies. Section 3 gives a review of the literature related to exchange market pressure. Different measurements of EMP in the previous researches will be summarized. In Section 4, the method used to measure the EMP of Turkey will be derived. The components are to be explained and interpreted. After that, the data will be described and the calculation results of each component will be presented. Then the EMP measure results will be demonstrated and analyzed. The conclusion will be given in Section 5.
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2. Economic characteristics and policies of Turkey
Since the ending of 2000-2001 economic crisis, Turkish economy has experienced a quick growth. The most obvious change is the real GDP (constant 2005 USD) which increased from 386.579 billion USD in 2001 to 653.164 billion USD in 2013. Indeed, since 2000 the GDP per capita in Turkey is increasing in general (see figure 1 in Section 1). Two downward jumps can be observed. From 2000 to 2001, GDP per capita jumps from 6119 US dollars to 5687 US dollars and GDP per capita growth jumps from 5.19% to -7.06%. From 2008 to 2009, GDP per capita jumps from 7730 US dollars to 7267 US dollars and GDP per capita growth jumps from -0.59% to -5.99% accordingly. Turkish GDP per capita is growing with high rate of 7.80% and 7.39% in 2010 and 2011 respectively. However, Turkey is encountering significant economic turbulence. The GDP per capita growth is decreased to 0.83% in 2012. In 2013, Turkey has a large current-account deficit of about 65 billion dollars which is 7.8% of GNP. In the same year, other emerging economies have the ratio of 3.5% for Brazil, 6.7% for South Africa, 4.3% for India and 3.3% for Indonesia. When the US Federal Reserve (Fed) signaled the end of its ultra loose monetary policy in late May 2013, capital flows began to reverse. An index measuring economic vulnerability of 15 emerging economies found Turkey the most vulnerable one (Fed Monetary Policy Report 2013)5. The Fed analysis also points out that the most vulnerable countries tend to experience the biggest currency depreciations as well as larger increases in interest rates for government borrowing.
In fact, Turkey‟s exchange market is also in turbulence as we introduced in section 1. To better approach the situation of exchange market of Turkey and measure the Exchange Market Pressure, we give a description of its exchange rate regime and monetary policies. Historically, before 1984 Turkey had adopted a fixed exchange rate. Turkey‟s exchange rate changed daily (crawling peg) between 1984 and 1993
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The index combines some indicators such as the total external debt to finance the trade deficits, public and private indebtedness, inflation, current account balance and the ratio of foreign exchange reserves to GDP.
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(Parlaktuna, 2007). From the 1970s through the 1990, Turkey suffered chronic and rising inflation. Monetary policy changed frequently and in the 1990s Turkish monetary policy targeted the real exchange rate. The Central Bank of the Republic of Turkey implemented a fixed or managed exchange rate regime before 2001. As a matter of fact, Turkish economy suffered from a high and persistent inflation during 1990s under that fixed exchange regime. The frequent policy changes, lack of transparency of the exchange rate policy and an associated scandal hurt the credibility of the Turkish central bank. In November 2000 Turkey experienced rapid financial outflows due to a loss of investor confidence. Restrictions on capital flows had been removed in 1990, but the underdeveloped financial system remained vulnerable to speculative attacks. The capital outflow created a domestic banking crisis and a large budget deficit, resulting in rapid monetary growth and currency devaluation. The exchange rate based stabilization program in 2000 ended with the deepest financial crisis of its history.
Due to the pressure from economic crisis, it is unrealistic to maintain an exchange rate target and insist on the previous currency peg regime, the managed exchange rate system collapsed in February 2001. Turkey switched to a floating exchange rate regime and started to use a flexible exchange rate system then. Although some countries announce that they have a floating exchange rate regime, they intervene anyhow. In 2002, the central bank‟s interventions were kept at a minimum, just as it has been the case since August 2001 and the central bank promised to only intervene in excessive fluctuations.
Following the crisis, policies were adopted in order to restructure and reform the economy. Institutional reforms were carried out, aiming to improve the role of markets, restructure national banks, increase independence of the central bank and transform monetary policy toward an inflation targeting regime. During the post-crisis period, the central bank has started to implement an “implicit inflation targeting”, where the role of the exchange rate in the policy-making process has been reshaped.
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Disinflation program was successfully implemented and, unable to maintain an exchange rate target. The transition to inflation targeting began in 2002 and was completed in 2006. In 2006, the central bank implemented complete inflation target system, the inflation target period is three years. A 3-year inflation forecast begin to be promulgated, meanwhile the communication strategy is also implemented. In addition, since 2002 the central bank of Turkey promises that they will use transparent methods destined to add foreign exchange reserves only when it is necessary. They also said the long-term trend of exchange rate and its natural equilibrium point would not be distorted. Moreover, they declared that the measures of the central bank would be pre-announced to the banks and the public pursuant simultaneously and transparently.
Influenced by the Federal Reserve‟s decreasing purchasing scale of its national debt and Turkey‟s unstable political situation, the foreign exchange rate of Turkish Lira has kept depreciating dramatically since May 2013. To the end of January, 2014, the Turkish Lira has depreciated against US dollar by more than 29%, to a new low point of 1 US dollar for 2.39 Turkish Lira. This has caused upheavals to its domestic financial market, and furthermore, endangered its economic increasing prospect. After consecutively dumping billions of foreign exchange reserve aiming at stabilizing its foreign exchange rate while resulting in little changes, the central bank declared before dawn on January 29 to increase the benchmark interest rate to 10%, from the previous 4.5%. Meanwhile the overnight lending and borrowing rates are both increased sharply in order to restrain the depreciating tendency of the Turkish Lira. The extent of the interest rate increases is far in excess of the market predication. It may help strengthening the market confidence in the short term, but for the long period, the main reason for the currency depreciation still exists, the fundamental shift of the situation could not come easily.
The external factors contribute a lot to this situation. Ever since the year 2013, the strengthening expectation of the USA exit from quantitative easing has made the
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funds flowing into Turkey decrease constantly. From the beginning of 2014, as a result of a stronger American economy expectation, a lot of money flow out of the developing countries, especially Turkey, a country which is dependent on foreign funds to balance its trade deficit. It faces even greater difficulties of lack of funds and currency devaluation. As for internal factors, the protest movements against the demolition of Taksim Gezi Park since June 2013 and the government senior officials‟ corruption scandal erupting in the end of that year in Turkey constitute are important reasons for the Turkish Lira depreciation. The protests damaged Turkey's political stability, resulting in the slump of Turkey‟s stock market and hit the tourism industry. A large amount of money began to withdraw for fear of instability of the political situation in Turkey, leading to the devaluation of its currency. Furthermore, from December 2013, Turkey's political turmoil worsened because of the anti-corruption storm, which directly triggered the financial market fluctuation and aggravated the downward pressure of its currency. In fact, under the floating foreign exchange rate regime (with intervention) implemented since 2001, instruments such as direct net foreign exchange purchases, export rediscount credits and reserve options mechanism were used and the CBRT foreign reserves saw a cumulative increase (see figure 4).
Since the international financial crisis, the international financial environment has experienced many ups and downs. For emerging market central banks, the challenge has become increasingly complex and arduous – it is not an easy thing to make choices among maintaining exchange rate stability, controlling inflation, or preventing the expansion of current account deficit. Turkey's central bank, which is a very unique case, even in the eyes of global central bank experts, the policy mix is complicated and confusing. At the end of March 2013, Turkey's central bank announced to reduce the interest rate corridor upper limit of the overnight lending rate by 100 basis points to 7.5%, and kept overnight deposit rate 4.5% and the benchmark interest rate unchanged at 5.5%, also announced to raise its deposit reserve rate. This is the third time of that year the central bank decided to cut
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its interest rates. The decrease of interest rates means easing of monetary policy, but it is puzzling to raise the deposit reserve ratio at the same time which apparently works the opposite way. During the winter of 2013, Davos forum, Turkey's central bank governor Erdem Basci explained how the central bank of Turkey tried to find a series of original, to some extent, special policy portfolio, including flexible interest rate corridor and its invention „reserve option mechanism‟ etc..
Interestingly, some policy tools of the central bank of Turkey will offset each other‟s effects. Turkey's central bank governor Erdem Basci thinks that central bank of Turkey has unique policies. They can use these tools to cancel each other out, while most central banks can only use for different tools for complimentary purpose. He also thinks that they have a dual reference target for the policies. It is important to know what tools will affect what variables. For example, the interest rate corridor and the policy rate itself are more associated with the risk of exchange rate. While the reserve and other tools are mainly for credit risks. So the simple way of communication is to illustrate respectively certain tools are implemented for certain risks including exchange market risks. The central bank of the Republic of Turkey‟s overwhelming mission is to achieve price stability and financial stability. As from the year 2014, according to the depreciation extent of Turkish Lira, the Turkey central bank keeps on its tightening monetary policy6.
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3. Literature review
3. 1 EMP components
3.1.1 Model- dependent approaches
In most literature, EMP is measured by a weighted average of exchange rate change and foreign reserves change, added the interest rate change after expanding. Authors extended the EMP measure by improving the expression of components and the applicability of weights. In some literature, EMP measures are derived from structural economic models.
Girton and Roper (1977) measure the “volume of intervention necessary to achieve various exchange rate target” from a highly restrictive monetary model. Under Girton-Roper framework, EMP is simply measured by the sum of the degree of fluctuation of nominal exchange rate and the rate of change of international reserves. This model-dependent measurement is applied to the postwar Canadian experience but possibly not the best choice in other situation because they concern Canadian monetary factors.
Weymark (1995 and 1997) proposes a generalized version of the measure above and derives model-consistent exchange market pressure formulae. According to her definition, EMP is “The exchange rate change that would have been required to remove the excess demand for the currency in the absence of exchange market intervention, given the expectations generated by the exchange rate policy actually implemented”. The more sophisticated monetary model is an improvement of G-R model but the EMP components do not change much.
Eichengreen et al. (1996) include the interest rate into the measurement of exchange market pressrure. They construct a weighted average of exchange rate changes,
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reserve changes and interest rate changes and measure the variables relative to Germany values. According to their views, policy makers can change the interest rate to influence the exchange rate and so as to offset the exchange market pressure.
Pentecost et al. (2001) derive a wealth-augmented model which expresses the exchange market pressure through the nominal exchange rate change and the foreign reserves change. They also include short-term money market interest rate differential change. The authors use principal components analysis to formalize the signed weights and consider it outperforms the volatility-smoothing weights. However, their weights reflect both the effectiveness of the components in offsetting pressure and the use level of the monetary authorities. This problem also exists in Eichengreen et al. (1996)‟s measure.
3.1.2 Model- independent approaches
Klaassen and Jager (2011) point out that the previous measure is not consistent with the definition of EMP. To make the measure definition-consistent, they develop a new EMP measure within the monetary model and then generate a novel EMP measure which requires fewer assumptions and is free from the restriction of exchange rate model.
Klaassen and Jager (2011) present an innovation in the measurement of EMP. They develop the practical implementation of the interest rate component in the new EMP measure by extending Taylor rule. The derived EMP measure is as follows.
EMPt = Δst + wi it − itd + wcct,
where Δst expresses the exchange rate change, ct is intervention magnitude defined as the central bank‟s forex market demand for domestic currency measured in domestic currency and itd denotes the hypothetical domestically desired level of the interest rate in the counterfactual of a passive policy maker. The weights are denoted by wi and wc. According to their expression, interest rate factor is considered in
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relative level form by it − itd instead of the traditional interest rate differential Δit used by Eichengreen et al. (1996). The two measures of interest rate component perform very differently in reflecting the truth. The cases of 1992-1993 crisis in the Exchange Rate Mechanism of the European Monetary System and the 1997-1998 Asian crisis are studied in their article, proving the plausibility of the new measure.
Based on the Taylor rule, Klaassen and Jager (2011) derive the counterfactual interest rate as follows, itd = i t ∗+ π t e − π t ∗e + γ∗ g t − gt∗ + γ − γ∗ gt+ (rteq − rt∗eq) 7
This provides a solution to the practical difficulty. However, some simplifications are implemented when applying the data because some variables are unobservable. It does no harm to the results in this case but ought to be considered carefully in other cases.
3.2 EMP weights
After having the components in EMP measure, we now briefly introduce the weighting methods. How much each component contributes to the exchange market pressure is an important question. Weymark (1997) considers the weights unknown parameters to be estimated. She derives the EMP weights from a structural model. But Eichengreen et al. (1996) find it very difficult to build good empirical models. However, instead of using a unweighted average they weight the components of exchange market pressure index to prevent dominating of any one of the components since the volatility of exchange rates, interest differential and reserves is very different. They simply use the ratio of the sample standard deviation of exchange rate change to the sample standard deviation of the correspondent components as the weights. It is called a volatility smoothing approach and applied by many authors.
7 π t
e is expected inflation. g
t is the column vector of relevant gaps. γ is the row vector giving the
policy preferences regarding the gaps. rteq is the equilibrium real interest rate. Asterisks denote the foreign country.
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Klaassen (2011) further extends the empirical econometric model that exploits the 4 time-series features of EMP and discusses the problems that might occur during estimation. He uses both estimation methods on data from the 1992-1993 European currency crises for France, Italy and the United Kingdom (all with Germany as the foreign reference country). The OLS estimator gives no significant effect for the weight whereas the IV estimate gives a significant positive effect, which shows a large difference for the estimation of weights in the EMP model. The cause of this difference is briefly explained to be caused by a large downward bias in the OLS estimate due to the presence of endogeneity.
3.3 Turkey review
To this day, not much literature has ever studied the exchange rate pressure in Turkey. In the existing literature, the Turkey EMP is always derived from certain monetary model.
Parlaktuna (2005) applies the Girton–Roper monetary model of exchange market pressure to Turkey economy. The EMP model reflects that through adjustments in both the balance of payments and the exchange rate, any excess domestic supply of money will be removed. According to the Ordinary Least Squares (OLS) regression analysis, the study concludes that there is a strong, negative and stable relationship between the domestic credit rate and the exchange market pressure rate. The test also shows that the measure of exchange market pressure is not relevant to its composition between foreign reserve and exchange rate. This is not consistent with previous literature focusing on other economies. In Parlaktuna (2005)‟s study, Turkey‟s experience indicates that most exchange market pressure is absorbed by adjustments in foreign reserves between the years 1993 and 2000, in which period Turkey is under a managed floating exchange rate system.
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currency crises in 1994 and 2001, as well as a number of unsuccessful speculative attacks that were resisted by the intervention of the Turkish Central Bank. Mete Feridun (2009) investigates the determinants of exchange market pressure in Turkey. Based on monthly data from August 1989 to August 2006, the results of the ARDL bounds test prove that exchange market pressure is in a long-run equilibrium relation with real exchange rate overvaluation, banking-sector fragility, and the level of international reserves.
In a country report (“Turkey: selected issues”) of the International Monetary Fund, a staff team of the IMF look at capital flows through the exchange market pressure prism. They use EMP index which is a weighted average of percentage changes in the nominal exchange rate and changes in central bank‟s foreign reserves divided by the base money to evaluate the forces behind the capital inflows from September 2008 to May 2013. They find that Turkey experienced outflows during 2008 to 2009 - the period of the Global Financial Crisis. Turkish currency is under the depreciation pressure then. Strong inflows appear from 2010 to 2011, which prompted the CBRT to adopt its unorthodox monetary framework. In late 2011, strong outflows start to happen and then are mitigated by an increase in the interest rates. The period 2012 to 2013 is of renewed inflows. The inflows last until summer of 2013. Due to the global environment and the local developments, pressure on the currency to depreciate does not happen again.
In the literature above, all the authors include foreign reserves and exchange rate changes but pay less attention to the interest rate factor. As a matter of fact, interest rates are affected by money market tools at various maturities. This may change international interest payments and influence investors‟ choices (Klaassen and Jager, 2011). Thus, excess supply could change accordingly. So interest rate is also a policy measure which offsets pressure and should be added to EMP measure.
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4. Empirical study
4.1 Methodology
Following Klaassen and Jager (2011)‟s study, let st denote the logarithm of the nominal exchange rate at time t. The exchange rate is a function of arguments it, ct, xt, where it be the short-term nominal interst rate and ct be the central bank‟s official interventions. They use ct = Ct/Vt as the extent of intervention policy instrument, where Ct is the central bank‟s foreign exchange market demand for domestic currency and Vt is foreign exchange market turnover. Other determinants are attributed to a vector xt. Argument xt is not supposed to be affected by it and official interventions.
We also leave out capital controls as Klaassen and Jager (2011) do because it is very complicated to measure and it is of not much influence on exchange market pressure of Turkey. As introduced in section 2, ever since recovering from the financial crisis of 2001, Turkey has been subjected to volatile capital flows, prompting its central bank to resort to a series of experiments where a set of various- not very traditional- tools have been employed in attempts to fend off too strong of inflows while dumping intensity of outflows. Some literature (e.g. Ma and McCauley, 2007; Huichison, Pasricha and Singh, 2011) indicate that the capital control could make a gap between onshore and offshore interest rates, which means the government can limit the excess supply or foreign demand of currency with capital control. The demand and supply influence the exchange rate. Thus, the capital control may give bias when measuring the EMP. However, literature that includes capital controls focuses on countries like China and India. According to the China-Ito Index (MenzieD. and Ito, 2006), the level of financial openness of Turkey is not significantly different from South Korea or Thailand, both of which were often involved in EMP measurement without the factor of capital control. Klein (2012) also indicated that the level of capital control of Turkey was not worse than many developed countries and medium developed
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countries such as South Korea, Poland, Portugal and Israel. Thus, no evidence has ever shown that the (more or less) capital controls have an effect on excess supply on the Turkish foreign exchange market. So it is not necessary to add the factor in our study.
According to the definition, exchange market pressure at time t is excess supply in the counterfactual without interventions. It is expressed as the depreciation required to remove the excess supply. So the exchange market pressure of Turkey can be expressed as follows.
EMPt = s 0, itd, xt − st−1. (1) where itd is the counterfactual interest rate- the rate chosen by the monetary authority without exchange rate objective.
Substituting st−1 by s ct, it, xt − Δst since Δst = s ct, it, xt − st−1 yields
EMPt = s 0, itd, xt − s ct, it, xt + Δst. (2) A vector vt can be found on the line segment between 0, itd, xt and ct, it, xt according to the mean value theorem such that
s ct, it, xt − s 0, itd, xt = sc vt ct + si vt it − itd , (3) where s ct, it, xt − s 0, itd, xt is expressed as a function of domestic interest rate relative to the counterfactual interest rate and official interventions.
Then we substitute (3) into (1) to derive
EMPt = Δst − sc(vt)(ct) − si vt it − itd . (4) Let wi and wc denote the differential of function s to the factor interest rate and interventions respectively at the vector vt. Then we get the main the equation of Klaassen and Jager (2011)‟s method
EMPt = Δst + wcct+ wi it − itd . (5) We can see from equation (5) that when there is excess supply of the domestic
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currency on the foreign exchange market, in other words, EMP > 0, three ways can be applied to alleviate the pressure. First is the depreciation of exchange rate (Δst > 0). Second is increasing the central bank‟s foreign exchange market demand for the domestic currency (ct > 0). Third is setting the interest rate above the level of the counterfactual rate (it− itd > 0). In this case, the weights w
c and wi should be positive. This paper would not focus on the weights in the measurement because it is too complex. Instead, we focus on the three EMP components.
In the literature review we have introduced that Klaassen and Jager (2011) use the interest rate in level form rather than interest rate in a fist-difference form. Because it could be counterintuitive when the interest rate is raised to a high level and kept constant for a period of time to ward off the pressure. The interest rate will be observed of no change in the first-differential form, which is apparently not a good reflection of the real situation. Moreover, the level of interest rate itself is not necessarily relevant to the pressure on the foreign exchange market. The difference between the actual interest rate and the counterfactual rate without exchange rate objectives can measure the pressure more accurately since domestic objectives are corrected in this way. This form of interest component makes sure that the measure of EMP is consistent with the definition.
However, the counterfactual interest rate itd is unobservable. To solve this problem, we calculate it by using Taylor rule suggested in Klaassen and Jager (2011)‟s paper. So Turkey‟s hypothetically desired level of interest rate can be expressed as a linear function of the differences of equilibrium real interest rate, expected inflation rate, relevant output gaps as well as other omitted monetary policy determinants. In short time period, the differences in equilibrium real interest rate, relevant output gaps and other cross-country omitted monetary policy determinants are relatively small and may not matter much. So we use it∗+ πte − πt∗e to measure counterfactual interest rate for practical simplifications, where it∗ indicates short-term interest rate of dollar assets, πte is expected domestic inflation rate and the asterisks indicates inflation in
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the US market.
In practice, we apply the temporal aggregation (Klaassen and Jagger, 2011) in the observation frequency. We get the monthly exchange market pressure expression
EMPm = Δsm + +wcmcm+ wim im − imd , (6)
where Δsm is the monthly exchange rate change, cm is the scaled change of foreign reserves. It is scaled Cm (end-of-month foreign reserve at month m) by a measure of base money supply: cm=−ΔCm/Mm−1, where Mm−1 is the end-of-month money supply of previous month, im is the monthly average of domestic interest rate and imd is the monthly average of counterfactual interest rate. According to the proxy described above, we have imd = im∗ + πme − πm∗e, where πme and πm∗e are expected domestic and foreign monthly average inflation respectively.
4.2 Data description
Klaassen and Jager (2011)‟s method will be applied to measure the exchange market pressure of Turkey from January 2006 to May 2014. First of all, we give a description of all the data needed in application. For a better sense, we introduce the data sources and data processing methods according to the classification of each component in the EMP measure and give some analysis in each part.
4.2.1 Exchange rate component
In application, we take the US as the reference country since the Federal Reserve is assumed to have no exchange rate target. Thus the exchange rate component Δsm is the first difference of the nominal spot value of Turkish Lira per US dollar at monthly frequency. Monthly exchange rates (end-of-month data) are obtained from the Central Bank of the Republic of Turkey (CBRT).
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In this section, we focus on the exchange rate itself first. The value of Turkish Lira is fluctuating in the foreign exchange market. Turkish Lira was first time over 1.5 against Dollar in the middle 2006 and then depreciated till 2008. We can see from figure 3 that Turkish Lira has gradually depreciated against dollar over time from 2008 to date. In middle 2013, the exchange rate rose above 2 Lira per Dollar. The end- of- month exchange rate was 1.1708 Lira per Dollar on January 1st 2008 and changed to 2.0935 Lira per dollar on May 30th 2014, during which process Turkish Lira has depreciated by 78.81%. We will calculate Δsm in next section then.
Figure 3 End- of- month exchange rate (Turkish Lira per US Dollar)
4.2.2 Intervention component
As mentioned in Klaassen and Jager (2011)‟s paper, official intervention on the forex market is an important policy instrument. Due to the availability of data and considering the importance of definition consistency, first we use scaled foreign reserve to measure the intervention: cm=−ΔCm/Mm−1.
Data of foreign currency reserves (end-of-month) in US dollars are obtained from Central Bank of the Republic of Turkey and will be adjusted to domestic currency by sm in calculation. Since 2006 the volume of foreign exchange reserves purchased by Turkey's monetary authority has accumulated from 52.538 billion US dollar in January 2006 to 108.678 billion US dollar in May 2014 (see figure 4). The foreign currency reserve is increasing continuously during the examined period.
0 0.5 1 1.5 2 2.5
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Figure 4 Foreign reserve (billion US dollar)
Data of the end-of-month money supply of previous month Mm−1 (measured by monetary base M1) are obtained from Central Bank of the Republic of Turkey.
Figure 5 Turkey money supply: M1 (billion Turkish Lira)
We also give the official intervention on the foreign exchange market according to the information from Central Bank of the Republic of Turkey. Data of official interventions are extracted from CBRT‟s publications and announcements from 2006 to 2014. As introduced in Section 2, Central Bank of the Republic of Turkey promised that their foreign exchange interventions are not intended to target any exchange rate level, but to control excessive volatility. Turkish foreign exchange interventions have two forms (Égert, 2007). One is discretionary interventions carried out on the foreign exchange market. The other is pre-announced foreign exchange auctions. The two
0 20 40 60 80 100 120
Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14
0 25 50 75 100 125 150 175 200 225 250
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forms of official interventions both influence the amount of foreign currency on the forex market. So we add the two interventions and adjust the amount to domestic currency. In order to compare the results, we also scale it by money supply.
4.2.3 Interest rate component
In Figure 6, im refers to the overnight interbank rate of Turkey and im* refers to the overnight interbank rate of the United States. Data of im and im∗ are both obtained from Datastream.
The interest rate of Turkey was always higher than the US one in the examined period. Before October 2008, Turkish interest rate was extremely high, fluctuating around 16%. After that, it dropped by more than a half, reaching 7% in October 2009. It decreases to 1.63% in December 2010 and goes back to 5% in the summer of 2011. Then this figure keeps steady for about two years, until a boost at the beginning of 2014. The trend of Turkish interest rate was similar to the US interest rate. The US short-term interest rate is much more stable than the Turkish rate. After the October of 2008, US rate falls to a very low level. The obvious phenomenon of downward going Turkish interest rate can by interpreted by excess supply of domestic currency. Recently, from January 2014, Turkish interest rate is raised to 8%, which is an instrument to combat the depreciation of Turkish Lira.
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im , im∗ Figure 6 im and im∗
First, we have a look at the real inflations at monthly frequency. Domestic inflation is measured by Turkey monthly CPI inflation. Foreign inflation is measured by US monthly CPI inflation. The data are collected from http://www.inflation.eu/. The inflation rate of Turkey (𝜋𝑚) and the inflation rate of the US (𝜋𝑚∗ ) fluctuated in similar tendency in the period from 2006 to date. During the whole examined time, the US inflation rate is far lower than the Turkey inflation rate. In the second half of 2008, the inflation of both countries rushes down. Values below zero appear on the US curve, which shows deflation in 2009. Compared with the US, Turkey is characterized as a high inflation country and the amplitude of inflation fluctuation of Turkey presented in Figure 7 is larger than the magnitude of the one of the US especially after the year 2009.
0 2 4 6 8 10 12 14 16 18 20 Jan -06 Ju n -06 N o v-06 Ap r-07 Se p -07 Fe b -08 Ju l-08 De c-08 Ma y-09 Oct -09 Ma r-10 Au g-10 Jan -11 Ju n -11 N o v-11 Ap r-12 Se p -12 Fe b -13 Ju l-13 De c-13 Ma y-14
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πm , πm∗
Figure 7 real inflation πm and πm∗
In the simplification of measuring the counterfactual interest rate introduced in methodology, we should know the expected inflations of domestic and reference country. Domestic expected inflation is measured by (median) expected CPI over the next twelve months. The data is obtained from the CBRT electronic data delivery system. Since expected inflation data is smooth, we take average of middle month data and end of month data as monthly average data. The middle month data is not available since 2013, so the end of month data is used after that time. Foreign expected inflation is measured by median expected price change over the next twelve months. The data is collected from Federal Reserve Economic Data. We can see from figure 8 that the expected inflation rate of Turkey (𝜋𝑚′) and the expected inflation rate
of the US (𝜋𝑚∗′) fluctuated in similar tendency in the whole period. Turkey curve is presented above the US curve during all the observation time, which is the same situation as showed in figure 7. Rushes in the middle 2008 can also be observed. We find similar features between expected inflations and real inflations. However, the expected inflations have smaller amplitude and seem more stable than the real inflation. -4 -2 0 2 4 6 8 10 12 14
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πm′ , πm∗ ‟
Figure 8 expected inflation πm′ and πm∗ ‟
0 1 2 3 4 5 6 7 8 9 10
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5. Empirical results and analysis
Definition- consistent measure of EMP indicates the change of exchange rate to remove the excess supply on the foreign exchange market without interventions. We intend to calculate the exchange market pressure indicated by each component in equation (6) on monthly basis so as to reveal the general trend of exchange market condition of Turkey economy. To observe how each component behave during the sample period and how much the exchange market pressure indicated by each component, after calculating each component we give some analysis of the figures and explain the details as well.
5. 1 Calculating each component
5.1.1 Calculating Δsm
Exchange rate is the price of domestic currency on the foreign exchange market. It fluctuates to clear the market and push it to equilibrium. When there is a depreciation pressure, the exchange rate of Turkish Lira defined as domestic currency price of one unit of the USD, tends to increase.
Here the exchange rate change is reported in figure 8. The positive Δsm implies the increase of exchange rate and reflects the excess supply of Turkish Lira in the market. The negative values of exchange rate change reflect excess demand of Turkish Lira in the foreign exchange market if the government interventions to offset the pressure are ignored. The exchange rate change Δsm in figure 9 is characterized by big fluctuations before 2009. Several upward jumps in Δsm are observed. First crest appears in May 2006. The following two crests in March 2008 and October 2008 arise in the period of financial crisis. The pressure of Turkish Lira depreciation in the component Δsm is most severe in October 2008. But after that period, the graph shows a stable fluctuation in the exchange rate component. The component is above zero for about half of the total sample period and is positive for the most time of 2013.
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Figure 9 Exchange rate change Δsm
5.1.2 Calculating cm
From figure 10 we can see that the volatility of monthly foreign reserve change relative to previous month is getting higher. The range of fluctuation is getting larger gradually. During the whole period, the actions of buying foreign reserve are more than selling. There are 65 months of positive value of Cm and 36 months of negative value. The highest amount of monthly foreign reserve accumulation change is in August 2012 and April 2013 with 7.953 and 8.134 billion US dollars respectively. From October 2008 to April 2009, Turkish monetary authority keeps selling foreign reserves.
Figure 10 Foreign reserve change relative to last month (billion US dollar)
-0.04 -0.02 0 0.02 0.04 0.06 0.08 0.1 0.12
Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14
-8 -6 -4 -2 0 2 4 6 8 10
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After scaled by the money supply, the fluctuation of intervention component is given in figure 11. The monetary authority decreases the supply of Turkish Lira in the foreign exchange market through selling foreign reserves. This is reflected by the positive value of cm. In the year 2006, only two months show positive value of intervention component. But from December 2012 to March 2014, positive value of intervention component exists in eight months. It might reveal some pressure of depreciation since positive value of cm can be observed in the period from October 2008 to April 2009. In the financial crisis, Turkish government sells foreign reserves to alleviate the exchange market pressure.
Figure 11 Interventions component cm (reserves-based)
Next we use the scaled official intervention to calculate the intervention component. It is denoted by cm′. The behavior of official intervention component is given in figure 12. We can observe an obvious valley in the beginning of 2006. On February 15, 2006, the Central Bank conducts a direct foreign exchange intervention by buying 5441 million USD in order to prevent the expected excessive volatility8. Then in June 2006, the Central Bank directly intervenes the market by selling reserves three times in total 3105 million USD. From the end of 2006 to September 2008 and August 2009 to July 2011, the Central Bank keeps buying reserves. Since August 2011, the Central Bank only sells reserves. Two peaks can be observed in July 2013 and January 2014. The
8 See Press Release on FX Intervention (2006-07) on the CBRT website.
-0.15 -0.1 -0.05 0 0.05 0.1 0.15
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two measures look very different at a glance. But they are generally consistent with each other in main crests and troughs because the change of foreign reserves could be caused by other reasons except for the adjustment to influence the exchange rate and only partly reflects the official interventions on the forex market.
Figure 12 Intervention component cm′ (scaled official intervention)
5.1.3 Calculating im− imd
When we consider the interest rate component, we should attention that a high interest rate does not necessarily indicate pressure since Turkey is implementing a strong monetary tightening in most of our sample period. Only by taking the difference between the real interest rate and the counterfactual interest rate can we get the extent to which the Turkish central bank uses the interest rate to chase exchange rate objectives. The counterfactual interest rate is the rate under no exchange rate purposes. As demonstrated before, 𝑖𝑚𝑑 cannot be observed directly but can be calculated by Taylor rule: 𝑖𝑚𝑑 = 𝑖𝑚∗ + 𝜋𝑚 − 𝜋𝑚∗ . The dark curve in figure 13 is the rate calculated by the real inflation. We also calculate the counterfactual rate by applying the data of 𝜋𝑚′ and 𝜋𝑚∗ ′ illustrated in section 4.2.3 and present the result 𝑖
𝑚𝑑′ by the light curve. In both ways of calculation, the counterfactual rate is above zero from January 2006 to May 2014. We can observe downward slopping tendency of the two curves during the year 2007 . It could be partly explained by the decreasing inflation of Turkey and
-0.15 -0.1 -0.05 0 0.05 0.1
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increasing inflation of the US during that period. Decreasing inflation in Turkey brings down the counterfactual interest rate and raises the value of interest rate component of EMP (see figure 14). So the exchange market pressure is affected positively. From January 2013 to May 2014, the amplitude of the counterfactual interest rate is becoming smaller and the rate is increasing relatively slowly. Basically the trends of counterfactual interest rate calculated with real inflation are consistent with the trends of the rate calculated with expected inflation. But the theoretically more correct result imd ′ is characterized much more stable than imd especially after the year 2009. We can observe big differences between the two results. So we do not think the real inflation can be applied in this calculation and will not adopt this method in the rest of the paper.
imd calculated with real inflation , imd ′ calculated with expected inflation Figure 13 counterfactual interest rate
Figure 14 illustrates im − imd ′ of Turkey, which is the difference between short term interest rate and counterfactual interest rate. The short term interest rate was always higher than the counterfactual interest rate except for the nine months from November 2010 to July 2011 and four months in 2013. Since depreciation pressure can be warded off by increasing the interest rate. This would increase the interest rate component and the interest rate differential has a positive sign. From January 2006 to
0 2 4 6 8 10 12 14 16
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October 2008, the difference between the short term interest rate and the counterfactual interest rate is getting bigger. After that period the value of interest rate component decreases continuously. This indicates that the Turkish Lira is under pressure before the crisis and recovers gradually after the crisis. The trend of downward shifting follows and continues to December 2010. After middle 2011, the interest rate component fluctuates within a small band until January 2013. It falls during the year 2013 and shows a sudden rise in the end 2013. The value of interest rate component increases to a relatively big degree and keeps that high in the observed period of 2014. It could be a signal of depreciation of Turkish Lira in the exchange market recently.
Figure 14 Interest rate component im − imd ′ (%)
5.2 EMP in Turkey
After calculating each component, we use the volatility smoothing approach (ERW weights introduced in Section 3) to aggregate the components and derive the EMP in Turkey on a monthly basis. Figure 15 gives the contour of EMP measures for Turkey. The dark line is the EMP measured with the intervention component based on foreign reserves. The light line is the EMP measured with the component based on real official interventions. The two measures are generally consistent with each other in signs and trends, especially before the year 2012. Different signs only can be observed occasionally. Inconsistency of the two measures appears during 2012 and 2013. In that period, EMP based on foreign currency reserves show negative signs in
-4.00 -2.00 0.00 2.00 4.00 6.00 8.00 10.00 12.00
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14 months, while EMP based on official interventions only show negative signs in 4 month. However, the EMP values of the two calculations are both high in January 2014. See from the light line, Turkish Lira is under the depreciation pressure for most of the period in question. Thus, the EMP measure based on foreign currency reserves can partly reflect the pressure of Turkish Lira on the foreign exchange market, but works not well in recent years.
EMP with component cm EMP with component cm′ Figure 15 EMP of Turkey
The four weighted EMP components are presented in the same figure to show their behavior and contribution to EMP. We can see from figure 16 that the interest rate component has larger amount and contributes more to the EMP before 2011. The exchange rate component fluctuates around zero across the sample period including some upward jumps. The contribution of the official intervention component to EMP varies much. Sometimes it presents a long-lasting effect. But sometimes the intervention component has relatively large ratio in the measurement of EMP.
-6 -4 -2 0 2 4 6 8 10 12 14
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Figure 16 EMP components
In accordance with the motivation of this paper, we now pay more attention to the situation in recent time. To get clear and detailed information, the EMP of Turkey with component cm′ from January 2012 to May 2014 is shown in figure 17 and each component is presented together in figure 18. During this period, the volatility of EMP is increasing. The largest value of EMP in 2012 is 1.389 in May and the smallest value is -0.190 in June. Then the EMP value fluctuates between -0.280 and 2.190. When it comes to December 2013, the EMP reaches 3.098 and in January 2014 the EMP hit a record high of 4.910.
Apparently, Turkey is not under a perfectly free floating exchange rate regime. The market-clearing exchange rate change is not a direct reflection of exchange market pressure. We thus include policy instruments when analyzing the pressure. Since August 5, 2011 the Central Bank of the Republic of Turkey started to supply foreign exchange liquidity to the market by foreign exchange selling auctions when it was considered necessary. In the direct foreign exchange intervention in January 2012, 1006 million USD was sold. In the same month, 1450 million USD was sold in the foreign exchange selling auctions. The Central Bank implemented additional monetary tightening via open market operations, foreign exchange sales and
-7 -5 -3 -1 1 3 5 7
Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 exchange rate component official intervention component interest rate component
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interventions. These policy instruments aim to prevent the negative effect on inflation expectations by exchange rate movements9. From February 2012 to May 2013, no official intervention on the forex market can be found. From June 2013, the official intervention component starts to increase and keeps above zero. A crest appears in July 2013, which indicates an auction of 5150 million dollars. On 23 January 2014, to arrest Lira slide the CBRT directly intervened the market by selling 3151 million dollars. We can see that multiple attempts of foreign currency sales have been carried to shore up the Turkish Lira but work only temporarily. The central bank has to resort to other instruments to halt the slide. Looking at the decision of the Turkey monetary policy committee on 28 January 2014, one would find that the CBRT raised the overnight interest rate to a high level due to a significant depreciation of Turkish Lira and an increase in the risk premium. Thus, all these changes to a big extent reflect the big pressure of Turkish Lira. We can observe in figure 17 that the peak of EMP appears in January 2014 accordingly.
Figure 17 EMP in Turkey of recent years
9
See Press Release on Monetary Policy to be implemented during Exceptional Days (2012-01) on the CBRT website. -1 0 1 2 3 4 5 6 Jan -12 Fe b -12 Ma r-12 Ap r-12 Ma y-12 Ju n -12 Ju l-12 Au g-12 Se p -12 Oct -12 N o v-12 De c-12 Jan -13 Fe b -13 Ma r-13 Ap r-13 Ma y-13 Ju n -13 Ju l-13 Au g-13 Se p -13 Oct -13 N o v-13 De c-13 Jan -14 Fe b -14 Ma r-14 Ap r-14 May -14
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Figure 18 EMP components of recent years
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 3 Jan -12 Fe b -12 Ma r-12 Ap r-12 May -12 Ju n -12 Ju l-12 Au g-12 Se p -12 Oct -12 N o v-12 De c-12 Jan -13 Fe b -13 Ma r-13 Ap r-13 Ma y-13 Ju n -13 Ju l-13 Au g-13 Se p -13 Oct -13 N o v-13 De c-13 Jan -14 Fe b -14 Ma r-14 Ap r-14 Ma y-14
exchange rate component official intervention component interest rate component
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6. Conclusion
In this paper, Klaassen & Jager‟s (2011) definition-consistent and model-independent exchange market pressure measurement was applied to the Turkish economy in the period January 2006- May 2014. We explored the economic conditions and characteristics of the foreign exchange market of Turkey. Monetary policies and exchange rate policies within the examined period are described in detail. According to the adopted definition of Exchange Market Pressure on a currency- its excess supply on the forex market if policy makers do not take actions to offset the excess supply- we then explored the measures of Exchange Market Pressure in existing literatures. We derived the EMP equation of Turkey by reference to Klaassen and Jager (2011)‟s study. Monthly data were collected and applied to calculate each component of Exchange Market Pressure. We then aggregate the value of each component using the ERW weights and present the EMP results of Turkey.
According to our empirical results, the exchange market pressure in recent years of Turkey indicated by the exchange rate change is positive in most of the time and a relatively stable fluctuation can be observed. We compare two ways of inclusion of the intervention component. One is the foreign currency reserves scaled by money supply. The other is based on the integration of information of forex market interventions from Turkish official announcements and publications. The intervention indicator is also observed positive more than before, especially since middle 2013. Turkish government is selling foreign reserves to alleviate the exchange market pressure on Turkish Lira. The interest rate component is positive in most of the time and fluctuates within a small band in recent years but increases sharply from the end of 2013. The components reflect the policy instruments implemented by the central bank to stabilize the Turkish Lira and alleviate the pressure. Put these components together, the volatility smoothing EMP values measured with both the two intervention components show a fluctuation on the positive side in most of the time but the results are divergent to some extent during the recent period. We conclude that excess supply of Turkish Lira exists on the foreign exchange market when the effects
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of actions to offset that supply by the policy makers are eliminated. Turkish Lira recently is under relatively big depreciation pressure against the US dollar on the exchange market.
For further study, four sides of development could be done. First, one can extend the time series. For example, the exchange market before 2001 can be explored and the exchange market pressure before and after the crisis of 2001 worth studying. It could be interesting to compare the results between that crisis period and recent period. But the exchange rate regime is not coherent. The fixed exchange rate system before 2001 and the managed floating system after 2001 could generate a difficult point. Second, the inclusion of intervention component could be further improved. But this could be restricted due to data availability. Third is a time-consuming large assignment- working out the weights. More theoretically correct and practically usable methods can be explored. Finally, other four countries of the “fragile five” can be studied and compared. One can reveal their common tendency or divergence. More information behind the EMP indices is worth exploiting.
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40 Internet: http://data.worldbank.org/ http://www.tcmb.gov.tr/ http://www.inflation.eu/ http://www.x-rates.com http://research.stlouisfed.org/
