Turkish economy heading towards a crisis

A market economist friend lamented to me on March 4 that all she could think about was the exchange rate. She was exhausted from talking to clients on the impact of the lira?s depreciation on the Turkish economy, and claimed that Turkey was heading for a crisis.

Her comments perplexed me, because Economy Minister Nihat Zeybekçi had noted earlier in the day that there was no reason to worry about the exchange rate. If that is indeed the case, why was Prime Minister Ahmet Davuto?lu in New York, trying to calm investors, on the same day?

Along with recent remarks from President Recep Tayyip Erdo?an?s chief economic adviser Yi?it Bulut that a new paradigm was being defined, Zeybekçi?s comments hint that an orderly lira depreciation is not feared, but actually desired. Could Erdo?an be trying to weaken the lira to make exports competitive?

Even in the standard textbook case, a weaker currency would increase a country?s export revenues only after a lag. Lower prices would drive down revenues first. But the increase in exports would eventually dominate the price effect, and revenues would rise. This mechanism is called the ?J-curve.?

Notwithstanding the fact that the relationship does not always hold, even in developed countries, it is complicated by additional factors in emerging markets (EMs). First of all, since many EMs import quite a lot of inputs as well as consumer products, there is a significant pass-through from depreciation to inflation.

In fact, what really determines the competitiveness of a country?s exports is not the nominal, but the real exchange rate, which takes into consideration the inflation differential between countries as well. Because of the exchange rate pass-through, Turkey?s real...