Exchange Rate: What factors affect it?

Exchange Rate: What factors affect it?

The exchange rate is a parameter you must follow if you live in a developing country. As you know, I have stated in my first post that I will use US Dollar for investment, not the local currency. However, I live in Turkey, and my salary income is in TL. I do not have a plan or foresight to live outside of Turkey in the coming years. Under the assumption that the floating exchange rate regime will continue in Turkey, the Dollar\TL exchange rate will also display ongoing volatility. This fluctuation necessitates fine-tuning in the accumulation period, investment decisions, and retirement periods.

This is not a problem for an American, for example. Because there is no such thing as currency risk for them. Salary income will be dollars, investments will be dollars, and retirement expenses will be dollars. The main threat to the average American is how inflation will occur in the future. However, if you are a developing country citizen and your investment portfolio includes TL and USD-denominated assets, you have to calculate the exchange rate risk and the inflation risk. Therefore, I believe understanding what factors affect the exchange rate will be beneficial when investing.

What does economic theory say about the exchange rate?

Turkey has been in the floating exchange rate regime as official discourse since the 2001 crisis. In the floating exchange rate regime, the value of the local currency is determined relative to the value of other currencies. In this case, as prudent individuals, we can predict that the rate will be determined depending on the local and economic variables of other economies. The economic theory also states that the exchange rate value (Dollar/TL) in the floating exchange rate regime changes according to inflation rate and interest rate differentials between the two countries. Of course, it is not limited to these: variables such as current account deficit, public debt, and terms of trade are also influential. Curious readers can check here for detailed information.

How do the interest and inflation rates of the USA and Turkey determine the rate?

All other variables being constant, a country’s high-interest rates increase capital inflows and an appreciation of its currency. By similar logic, all other variables being constant, a country’s low-interest rates cause an increase in capital flows out of the country and a depreciation of its currency. For example, the Central Bank of the Republic of Turkey recently cut the policy rate by nearly 5%. The theory predicts that this move will cause the TL to depreciate while all other variables are constant. Of course, other variables do not remain constant in real life. Therefore, a decrease in the value of TL may not occur immediately. As a matter of fact, in real life, TL appreciated – albeit for a while – immediately after the interest rate cut. However, this does not mean that the theory is wrong. On the contrary, these variables are determinative of the exchange rate in the long run.

Interest rates differential

In the chart below, you can see the change in the monetary policy rate applied by the FED over time. Shadow areas show recessions or contractions in the US economy. You can clearly see from the picture that after the 2008 crisis, the FED almost zeroed policy rates and tried to grow the economy.

ABD Merkez Bankası FED'in politika faizi oranı 1980'li yıllarındaki zirveden sonra sürekli bir düşüş eğilimi sergilemiştir.
Monetary policy rate

Let’s take a closer look at the period. In the chart below, we see the Fed’s policy rate again. After the 2008 crisis, the interest rate was quickly lowered. The chart below shows the weighted average funding cost of the Central Bank of the Republic of Turkey. In fact, the one-week repo rate was called the monetary policy rate. However, due to the Government’s ideological approach to interest rates, the Central Bank bureaucracy prefers to use indirect methods rather than openly changing the policy rate. Curious readers can examine the writings of Mahfi Eğilmez and Uğur Gürses on this subject. Let’s go back to the chart of Turkey. The Central Bank’s weighted average cost of funding ratio remained flat until 2018. It increased rapidly due to the exchange rate shock in 2018. If you look carefully at the graphs, you may notice that the rate of the FED started to increase as of 2015. While the monetary policy rate of the Central Bank of the Republic of Turkey followed a year or two behind.

ABD Merkez Bankası FED, politika faizini ekonomik krize tepki olarak 2008 yılında ciddi ölçüde düşürmüştür. Faiz politikasında normale dönüş ise 2015 yılından itibaren başlamıştır.
The monetary policy rate (2008 – 2019)

TC Merkez Bankası'nın politika faizi FED'i geriden takip etmiş, Dolar/TL kurunda 2018 yılında görülen hızlı artışı durdurmak için ciddi bir faiz artışı yapmak zorunda kalmıştır.
The weighted average funding cost of the Central Bank of the Republic of Turkey

Inflation differential

Let’s talk about inflation. The chart below shows the US Consumer Price Index change between 2003 and 2019. While the index was around 182 in 2003, it reached about 255 in 2019. Total inflation is about 40%. I added another chart that shows the Consumer Price Index calculated by the Turkish Statistical Institute. In the same period, the index value increased by approximately 400%. In other words, inflation in Turkey has been 400% in the same period! According to economic theory, the currency with higher inflation depreciates against the country with low inflation, all else equal.

ABD Tüketici Fiyatları Endeksi doğrusal bir artış sergilemektedir. 2003 yılından günümüze gerçekleşen toplam enflasyon yaklaşık % 40'ı bulmaktadır.
US Consumer Price Index

Türkiye İstatistik Kurumu'nun yayımladığı Tüketici Fiyatları Endeksi üssel bir artış eğilimi sergilemektedir. 2003'den günümüze kadar gerçekleşen toplam enflasyon % 400'ü bulmaktadır.
Turkish Consumer Price Index

So what happened to the dollar/TL exchange rate in this period?

To answer this question, I prepared a monthly chart of the Dollar/TL rate using the statistics database of the Central Bank of the Republic of Turkey. As you can see from the chart below, the dollar rate remained relatively calm between 2008 and 2014 and appreciated somewhat. The depreciation of TL accelerated afterward. After the severe interest rate hikes in 2018, the exchange rate returned from its peak. As a result, Turkey increased its interest rates later than the USA and did not fight inflation seriously, allowing for a very high inflation rate. Therefore, it is not surprising that the TL depreciated. The question arises as to whether the depreciation of the TL would have been so high if Turkey’s economic administration had increased interest rates simultaneously with the FED.

Dolar/TL kuru 2013 yılından itibaren hızlı bir artış sergilemektedir.
Change in USD/TL exchange rate

Is it possible to predict the exchange rate?

Yes, it is possible to estimate the exchange rate. In fact, all economic actors who have a business with foreign exchange forecast exchange rates. There is no problem in making predictions. Whether the prediction will hold or not is a separate issue. At this point, it is worth emphasizing that financial markets act with a herd mentality. They are intertwined; for example, the Dollar/TL exchange rate can be easily affected by the change in the South African Rand or Argentina’s default. It is described as financial contagion. For example, when global investment funds incur losses in another developing country, they can exit TL assets and reduce their losses. This is why economists rightly avoid making exchange rate forecasts.

Nevertheless, the necessities of daily life force economic actors to make exchange rate forecasts. The financial sector, for example, estimates the exchange rate using the theory when a forward exchange rate forecast is required. It is practical and straightforward. Currency can also be calculated using econometric methods. However, econometric methods act on the assumption that the past dynamic will continue in the future. In an environment where it is impossible to predict what will happen tomorrow, these methods do not make much sense.

Economic crisis and Dollar/TL rate

For any numerical forecasting model to function with an acceptable margin of error, actors, especially economic management, must be rational and consistently follow the same policies over time. Thus, predictability is ensured for investors. However, this is not the case in Turkey. If you remember the month of August 2018, you will remember the great panic when the dollar was above 6 TL. Eventually, politicians refrained from raising interest rates allowing the Central Bank to raise interest rates very high. Then the Turkish Lira was appreciated against the US Dollar. As an investor, I would like the dollar rate to be stable. Thus, it would be possible to make healthier investment decisions.

Real effective exchange rate

We can also see the fluctuation in the value of TL by looking at the real effective exchange rate. The difference between this indicator from a standard exchange rate is that it shows the value of TL by considering the exchange rates of Turkey’s commercial partners in proportion to their weights. Again, based on the data published by the Central Bank, I prepared the graph of the real effective exchange rate since 1995. The green line shows the mean, and the dashed lines show the standard deviations. The average value is 100.3. The top of the green line shows the region where TL is valuable relative to the currencies of Turkey’s trading partners. The bottom of the green line shows the area where it is less valuable. Two points caught my attention: First, TL has depreciated since 2013. Secondly, during the 2018 exchange rate shock, TL saw its lowest level during observation. However, there seems to have been a partial recovery with a massive interest rate hike.

Reel Efektif Döviz kuru Türk Lirasının değerini dış ticaret partnerlerinin paralarına göre göstermektedir. 2013 yılından itibaren Türk Lirasının değeri düşmektedir.
CPI-based real effective exchange rate

Will the USD/TL exchange rate continue to increase?

Nobody knows the future. How the Dollar/TL exchange rate will move in the long run will depend on the government’s policy, other countries’ interest rate and inflation policies, the state of the world economy, etc. However, my personal opinion is that the fight against inflation is not among the priorities of Turkish politicians. If I am correct in this opinion, inflation will continue to be relatively high in Turkey in the coming years compared to other countries. In other words, in the long term, TL will continue to depreciate against the Dollar. I hope to be wrong.

So, has the USD/TL rate increased?

I wrote the above article about 3 years ago. I have shared the English translation with you now. So what has happened in the Dollar/TL exchange rate since then? Let me put it this way: Year on year, inflation has reached 80%. This is official statistics. Independent academic researchers estimate annual inflation year on year at 170%! Yes, you heard right. In line with economic theory, the Turkish lira depreciated tremendously against the US dollar. You wonder how I keep investing to reach financial independence in such an environment. Keep reading this blog.


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