Fiscal Imbalances, Capital Inflows, and the Real Exchange Rate: The Case of Turkey

This paper examines the links between fiscal policy, uncovered interest rate differentials, the real exchange rate, and capital inflows in Turkey since the late 1980s. The first part reviews recent macroeconomic developments in Turkey. It shows that capital inflows coincided with a period of significant deterioration in fiscal balances, high interest rates, and an appreciating real exchange rate. The second part estimates a vector autoregression (VAR) model that includes the temporary component of the real exchange rate, government spending and (net) private capital inflows, both measured as a percentage of GNP, as well as the interest rate differential adjusted for exchange rate changes. Although the constraints imposed on the specification of the VAR by the small sample size prevent firm conclusions, the findings are broadly in line with recent macroeconomic developments in Turkey: positive shocks to government spending lead to an appreciation of the temporary component of the real exchange rate, while capital inflows respond to shocks to uncovered interest rate differentials; positive shocks to capital inflows also lead to an appreciation of the temporary component of the real exchange rate. The analysis highlights the importance of fiscal adjustment for restoring macroeconomic stability in Turkey. Although the real appreciation observed in the early 1990s appears to have had a relatively weak effect on the growth rate of exports, it contributed to a sharp increase in imports and a deterioration of the current account balance. As illustrated by the currency crisis that took place in early 1994, market correction of real exchange rate misalignment may occur in traumatic fashion and may be associated with increased volatility in asset prices and disruptions in economic activity. Restoring fiscal equilibrium would promote a moe orderly adjustment in relative prices.