The Policy Challenge with Floating Exchange Rates: Turkey’s Recent Experience

Abstract

This paper evaluates the developments in the Turkish economy in light of the Central Bank of Turkey's (CBT) policies during a recent period of floating exchange rate system (March 2001-July 2003). It is found that the CBT was effective in containing volatility and reducing the average inflation rate while there was a strong recovery of output. However, there are accumulated risks in the economy. Particularly, the extreme appreciation of the Turkish lira during this period and the record level of real interest rates give the impression that the current state of the economy is fragile. Unless the government accelerates the structural reform process and pursues sound fiscal policies to reduce the public sector borrowing requirement and the debt ratio, an adverse shock to the system may trigger a reversal of fortune.Imagine an economy with an ever-rising domestic debt and record real interest rates, a high and persistent inflation, an extremely weak and shallow banking sector (occasionally, with some corrupt bankers), political instability, and a geographical location with constant turmoil in neighboring countries. On top of this, add a dramatic collapse of a fixed exchange rate based stabilization program which resulted in a market-forced devaluation followed by a floating exchange rate regime. Is it possible to conduct a policy such that the volatility of the exchange rate may be contained and the implicit inflation targeting may result in significantly lower inflation rates while real output growth picks up? The recent developments in the Turkish economy show that the answer is yes but with a significant risk remaining in the economy.February 19, 2001 was a major turning point in Turkish political and economic history. That day, Turkish Prime Minister Bulent Ecevit announced that there was a serious "dispute'' between himself and the country's President. He further emphasized that "of course, this is a serious political crisis'' without elaborating the future of the government or the ongoing stabilization program which aimed at lowering inflation with a fixed nominal exchange rate depreciation. The same day the stock market dived 18 percent and the Central Bank of